I
write in support of the DOL’s proposed Conflict of Interest proposed rule and
to suggest enhancements to the BIC exemption, and to further suggest a new
exemption relating to IRA rollovers.

As
a longtime researcher into fiduciary law as applied to financial and investment
advisers, I currently serve as Asst. Professor of Finance at Western Kentucky
University, Bowling Green, KY, where I Chair the undergraduate (B.S. Finance) Financial
Planning Program with the Gordon Ford College of Business and teach classes in
retirement planning and investments. I am also an investment adviser, having
served as the Director of Research, Chair of the Investment Committee, and
Chief Compliance Officer of an SEC-registered investment adviser firm, and I
currently serve as the principal of my own registered investment adviser firm.
I am also currently a Certified Financial Planner™, a member of the Steering
Group for The Committee for the Fiduciary Standard, consultant to the Garrett
Planning Network, and a member of both the Financial Planning Association (where
I served on its “Fiduciary Task Force” and “Standards of Conduct Task Force”) and
the National Association of Personal Financial Advisors (where I served on its
national Board of Directors, and where I currently serve on the South Region
Board of Directors). In the past I served as a consultant to a large financial
services firm on a program relating to retirement planning. I am also a member
of The Florida Bar, and have advised clients on tax and estate planning issues.
I have previously commented extensively on fiduciary rule proposals and often
provide writings and presentations on the topic. These comments represent my
personal views.[1]

First, I desire to express my personal gratitude for the
courage shown by the White House, the Secretary of the DOL, and Asst. Secretary
Borzi and her dedicated staff, as they seek the necessary changes to better the
retirement security of our fellow Americans. The tenacity shown to effect these
much-needed updates to the standards of conduct applicable to the delivery of advice
to retirement accounts are particularly noteworthy, given the flood of money
and resources flowing from many Wall Street firms and their lobbying
organizations into Washington, D.C. in an effort to delay or halt these
important and long-overdue changes.

Second, I provide the rationale for the imposition of
fiduciary standards upon providers of investment advice to ERISA-governed
retirement accounts and individual retirement accounts (IRAs). This requires an
understanding of the high rent extraction by most providers of financial
products today, and the monumental adverse affect of this extraction of rents
by Wall Street. These high rents not only hinder the retirement security of
hundreds of millions of our fellow Americans, but also hinder the growth of the
U.S. economy and the future economic prospects for all Americans.

Third, I provide a discussion of a bona fide fiduciary
standard, and contrast the authentic “best interests” fiduciary standard of
conduct with the wholly misleading and ineffective “best interests” standards
of conduct now proposed by SIFMA and most recently by FINRA. I urge policy
makers, such as those in Congress and in our regulatory agencies, to not be
fooled by these 11th-hour attempts to deter the expansion of true
fiduciary duties.

Fourth, I comment on the “Best Interests Contract
Exemption,” also known as the BIC exemption. I provide suggestions which will
serve strengthen the exemption and lead to better personal financial outcomes
for our fellow citizens, as (given the advocacy by SIFMA on its “best
interests” proposal, and other attempts to re-define commonly used legal terms)
there is a danger that the term “best interests” will be, in the future,
interpreted incorrectly.

Fifth, I recommend the adoption of a new prohibited transaction
exemption (PTE) for independent investment advisers who are bound by the “sole
interests” standard of ERISA, regarding the conflict of interest all providers
of personalized investment advice possess regarding the important decision of
Americans as to whether to undertake a rollover of a qualified retirement plan
(QRP) account into one or more individual retirement accounts (IRAs).

Sixth, I comment on the “Seller’s Exemption.” There has
been a long history of “expert advisers” failing to provide excellent and
non-conflicted advice to retirement plan sponsors. I propose some enhancements
to this exemption.

Seventh, I observe that it is extremely easy to
reconcile different standards of conduct advisers might practice under, under
different regulatory regimes, despite the assertions by FINRA, broker-dealers
and insurance companies to the contrary.

I also hereby incorporate by reference my previous
comment letters regarding a previous version of the proposed rule.[2] These
letters set forth additional legal authority for the propositions contained in
this letter. I attempt to not duplicate these earlier submissions, except as
necessary to address the specific issues raised by this important proposed rule
and the new or modified PTEs associated therewith.

Thank you for your consideration. I would be pleased to
discuss this proposal at your convenience with Department staff. By separate
submission I have requested to testify at the DOL’s August 2015 hearing on
these matters.

Yours truly,

Ron
A. Rhoades, JD, CFP®

COMMON
SENSE 2015:

ADDRESSED TO THE

INHABITANTS

OF

AMERICA,

on the following interesting

SUBJECTS.

I. On the Failure of the Financial Services Industry to serve
the Public Good

Jake
and Missy Compton Seek A Second Opinion. Jake and Missy Compton (not their real names, for
reasons of confidentiality), husband and wife for the past 10 years, and both
in their early 40’s were doing relatively well financially. Jake was an
executive at a multi-national company with a compensation package that was
mid-six figures. Missy was attentive to the needs of home and her husband,
diligently saving, paying bills, planning each modest vacation for maximum
enjoyment, and ensuring no debt (other than their very-low-interest-rate
mortgage) was incurred. After maximizing contributions to Jake’s 401(k) plan and
electing to defer as much income as possible in the company’s nonqualified
compensation plan, over the past several years the Comptons were still left
with extra funds to invest. After several years of investing with the current
wealth manager, Jake and Missy sought me out for a “second opinion.”

Before beginning to invest with
their existing wealth manager, several years before, Jake and Missy already had
investments. In addition to their condominium (their home, in a major city),
Missy owned two condominiums in another state. These rental properties were
generating positive cash flows for Jake and Missy.

Several years before a friend had
previously referred the Comptons to the wealth manager’s firm. This “wealth
management” firm’s stated policy, per their web site (retrieved 2/22/15) was
“to provide independent and sound investment advice whatever your
financial situation … trust is
important.” (Emphasis added.) The
firm also held out as “your expert
partner in all things financial.” (Emphasis
added.) The wealth manager they were referred to, a founder of the firm,
touted his ability to “compete based on knowledge, relationship and world class
service.” My review of the wealth manager’s registrations revealed that he was
a dual registrant (i.e., possessing
registration as both the registered representative of a broker-dealer firm and
as the investment adviser representative of a registered investment adviser
firm), and that he also possessed life insurance and annuity provider state
licensure.

The wealth management firm
suggested, for the Comptons, investments in many different types of accounts –
traditional and Roth IRA, joint, and individual (taxable) accounts. Many
different types of investments were undertaken. Variable universal life (VUL) insurance
policies were also recommended and sold to both Jake and to Missy by the wealth
manager. A nonqualified equity indexed annuity (EIA) was also recommended and
sold to Jake.

After a few years, as Missy reviewed
the many monthly and quarterly statements she received, she thought something
might be amiss. She couldn’t put her finger on it, but she suspected that
things were “not right.” Despite the tremendous increase in stock market values
over the past few years, it appeared that the value of their investment portfolio
was substantially lagging.

After reading an article I had
written years before, Missy contacted me for a second opinion, to which I
consented. (I call such second opinions or portfolio reviews “BearScans,” as my
students often refer to me as “Da’ Bear” – perhaps due to my size or perhaps
because I may growl at them.) I gathered detailed information from Jake and
Missy Compton, including about their lifestyle, spending habits, past personal
history, and goals, as well as monthly or quarterly statements of all of their
investment accounts.

The
Compton’s Retirement Goals. Jake
desired to retire in about 15 years, and he believed that he was well on his
way to doing so. With no children and none expected, Jake and Missy were not
anticipating any major expenses prior to retirement. Working for a
multinational company, Jake felt his position was very secure. The Comptons
desired to retire to a state that had no state income tax. Their accumulated
deferred compensation was invested per the plan at a rate slightly exceeding
the prime rate, with no interest rate risk present. Additional contributions to
the deferred comp plan were likely.

Compton’s
Tax Return Reveals Unnecessary Tax Drag on Investment Returns. Even with the substantial deferred
compensation arrangement, their recently prepared Form 1040 showed that their
marginal tax rate was 28% for federal income tax purposes, and additional state
income tax was paid. They possessed $9,000 of net capital loss carryforwards
(NCLCF). Their tax return for the prior year indicated over $18,000 of ordinary
dividend income and $4,000 of qualified dividend income. Three of their taxable
investment accounts had generated realized net short capital gains exceeding
$5,000, and five of their taxable investment accounts had generated realized
net long-term capital gains exceeding $21,000. Due to a combination of
deductions for state income taxes, the presence of qualified dividends, a small
amount of tax-free interest income, and their long-term capital gains, the
Comptons were subject to alternative minimum tax.

At first glance, the amount of
nonqualified dividends seemed alarming, as were the realized capital gains from
publicly traded investments. The continued realization of long-term capital
gains would likely result in increases to their alternative minimum tax
liability.

No
Investment Policy for the Comptons. I
then turned to Jake and Missy’s investments, made on the advice of their
current wealth manager. First, I inquired, had an “Investment Policy Statement”
been prepared by their current wealth management firm? No, the clients
responded, inquisitive as to what an Investment Policy Statement was all about.
The Comptons indicated that they would be contacted by their wealth manager
whenever they contributed cash to their accounts, and recommendations would
then be undertaken and discussed verbally. But they did not recall any “asset
allocation” target percentages being discussed.

The
Compton’s Oil & Gas Limited Partnership. The immediate question Jake and Missy posed to me was
whether they should invest more into an oil and gas limited partnership, which
recommendation they just received from their wealth manager just one week
before they contacted me (in Nov. 2014). Of their total in the investment
accounts with the wealth manager, nearly 20% had been invested in oil and gas
limited partnerships with this same master general partner. A review of the
investment revealed that outside investors in nearly all of the private
placements arranged by the master limited partner either lost money or just
about broke even. In fact, the limited partnerships were so poorly designed, so
as to benefit the master limited partner over the limited partners, that a law
firm had posted a notice stating that it was “interested in hearing from
investors who have lost money investing in [the master limited partner’s] oil
and gas investments.” With such red flags appearing, and with dramatically
falling petroleum prices in the Fall of 2014, it was readily apparent that the
risks of the investment outweighed the potential for returns, and I discouraged
the Comptons from purchasing any more of these partnership interests.

While Jake and Missy extolled the
tax credits they had received from these investments, and the current 6%
dividend yield, I explained that the dividend was likely to fall in the months
ahead as oil and gas revenues declined (which it subsequently did – quite
dramatically). I also explained the “tax tail” should never wag the “prudent
investor” dog. Tax credits would not offset the fact that their investments in
these limited partnerships were highly unlikely to generate any reasonable rate
of return. One does not invest to generate losses, but rather to generate
gains. This fundamental truth seems have to been ignored by their wealth
manager, at least with respect to these investments.

I also pointed out that the limited
partnership interests were highly illiquid. In fact the value of these
(non-liquid) investments had already likely fallen substantially. This was
confirmed later when, seeking to sell one of their existing limited partnership
interests, the best offer the Comptons received was for about 13% of the
initial purchase price they paid for the units.

Why did their wealth manager
recommend such a poor investment? Especially in November 2014, when despite
rapidly falling oil prices the wealth manager recommended an even greater
amount be invested? The answer appeared obvious. The sale of the limited
partnership interests netted the “wealth management firm” commissions in the
range of 10% to 15% - far in excess of the commissions which would have been
charged had the Comptons purchased a mutual fund (especially when breakpoint
discounts are applied).

Review
of the Compton’s Other Tax-Inefficient and Costly Investments. I then turned to other accounts Jake
and Missy possessed.

First Taxable Account. I would have expected that
tax-efficient investments would be utilized and that avoidance of realization
of capital gains, especially of a short-term nature, would be sought. Yet, the
stock mutual funds possessed in these accounts had relatively high turnover and
were woefully tax-inefficient. Some of the mutual funds held in the account
were municipal bond funds; yet, these funds held few bonds in the Compton’s
state of residence (leading to state income taxation of the otherwise
“tax-free” interest income.)Another
concern in this account was the layering of fees. In addition to investment
advisory fees paid to their wealth management firm (which appeared to be about
1% a year, per the firm’s Form ADV), another advisory firm (“separate account
manager”) was called upon to select the funds and was likely paid a fee of 0.6%
to 1.0% according to its Form ADV. Then there were the fees and costs of the
mutual funds themselves. A short review indicated annual expense ratios (AERs)
as high as 1.91%, with most of the stock mutual funds possessing AERs exceeding
1%. Additional costs would be incurred within the stock funds – i.e., various
transaction and opportunity costs due to the high amount of securities trading
and sometimes relatively high cash holdings.

Second Taxable Account. Several stock and asset allocation
funds were used in the account, all of which possessed relatively high
portfolio turnover rates. The annual expense ratios of the mutual funds ranged
from 0.89% to 1.25% for the three largest holdings in the account. Again,
relatively high cost funds existed. With an allocation of 27% of the account to
fixed income investments and most of the balance to stock mutual funds which generated
substantial realized capital gains as well as taxable interest income, the
account was not invested tax-efficiently.

Review of the Compton’s Non-qualified Equity-Indexed
Annuity. Jake was
also sold a nonqualified equity-indexed annuity (EIA), the value of which was
less than the value shown on their brokerage statement, as surrender fees still
applied (which reduced its actual market value). When I explained the likely
rates of return of the EIA’s various investment options (given the crediting
mechanisms and the caps), the tax restrictions on taking funds from the
non-qualified annuity prior to age 59½, and the large commission paid to their
wealth management firm upon the purchase of the EIA, Jake was not pleased. What
struck me, as well, was that given the substantial qualified (401k) and
nonqualified (deferred compensation) plans in which Jake was enrolled, there
did not appear to be any good reason, from an overall tax planning perspective,
to contribute to any non-qualified tax-deferred accounts.

The Compton’s Non-Publicly Traded REITs. The Comptons had also been sold
two REITs by the wealth management firm. Both were non-publicly traded. Given
the Compton’s other privately held real estate investments, any additional asset
allocation to real estate was inappropriate. In addition, the REITs (which
generate ordinary income, most of which must be distributed to the owners of
the REITs) were held in taxable accounts. More alarming was the fact that the
initial offering price of the REIT was still being utilized for purposes of
valuing the shares on the statements, despite the fact that commissions of
8-10% and additional “marketing expenses reimbursements” were paid to the
various brokerage firms that sold the REIT. A recent spreadsheet provided by their
wealth manager indicated that this investment had “no fees” that year (perhaps accurate,
but only in the sense that the large commission had already been paid and no
investment advisory fees were paid on these investments). I explained to Jake
and Missy that REITs pay their managers (or outside managers) fees to manage
the properties, and other expenses exist within the REIT itself. I also
explained that the value of the REIT was likely far below the value listed on
the brokerage statement.

The Expensive Futures Ltd. Partnership. Jake and Missy also possessed a
taxable (joint) account, invested in a non-publicly traded limited partnership
that invested with other “Trading Advisors” who in turn invested primarily in
futures contracts. One Trading Advisor’s compensation was 2% and 20% of the
“net new trading profits.” Others had compensation of “0 and 30%” or “0.75% and
25%” or similar. In addition, the limited partnership charged an annual
management fee of 1.5%, plus 7.5% of the new profits calculated monthly.
Selling agent fees also were 2% annually. To the Comptons I explained the
likely long-term returns of commodities, as an asset class, the historical
returns of commodities, the tax implications of the fund, as well as the many
layers of fees and costs. I also explained the lack of liquidity for this
investment. Needless to say, the Comptons were again not pleased with their
wealth manager’s advice to invest in this investment product.

Roth IRA Investments – What the Hell? I then reviewed the Comptons’ Roth
IRA accounts, invested in a mix of U.S. and foreign stock funds as well as some
bond funds. Of course, two things stood out immediately. First, foreign tax
credits can result from international stock mutual funds, which flow though to
U.S. owners of those funds when held in taxable accounts. These tax credits are
lost when the international stock mutual funds are held in Roth IRA or
tax-deferred accounts. Second, fixed income investments have no place in this
Roth IRA account. Roth IRAs generally grow income tax-free, and these accounts will
likely be the client’s last source of withdrawals during retirement.
Accordingly, allocation to the asset classes with the best expected long-term
returns would be far more appropriate.

Very Expensive VUL Policies. Both Jake and Missy had variable universal
life insurance (VUL) policies that which were sold to them by the wealth
manager in 2010. Missy’s death benefit was $381,000, and her accumulation value
was $57,377. Jake’s policy had a death benefit of $336,000 and an accumulation
value of $54,000. The accumulation values remained far below the total premiums
paid, given the high commissions paid to the wealth manager during the VUL
policies’ first few years.

I would never have recommended
permanent life insurance for them. The only need for life insurance was to
replace Jake’s lost income, or cover possible expenses upon Missy’s end of
lifetime. I would have recommended term policies, with a far larger death
benefit for Jake and far less of a death benefit for Missy (as she did not have
earned income).

It should be noted that there was no
need to secure liquidity to pay estate taxes. In fact, during the year the
policies were sold to the Comptons (2010), the federal estate tax did not
exist. In December 2010 the federal estate tax exemption was established at $5m
for 2011 (with increases tied to inflation thereafter, and with spousal
portability). There simply was no need for the clients to possess permanent
life insurance. I surmised that the only plausible reason that the Comptons
were sold these policies was due to the fat commissions paid to the wealth
manager.

However, since the Comptons already
possessed these policies, and had paid hefty commissions on the premiums paid and
since the policies still possessed surrender fees, more analysis was needed to
determine whether to continue with the policies and/or continue to pay
premiums. In-force projections would have been ordered, using conservative
rates of return and with minimal or no future premiums paid. Comparisons of
mortality fees paid under the policy, to the insurance charges from new term
insurance policies, would also need to be undertaken. Regardless of whether,
following more analysis, the current policies will be surrendered or not, more
term life insurance for Jake was likely needed, which will be handled through
one or more new term life policies.

The Compton’s Non-Managed 401(k). Jake also had a 401(k) with his
company. Fortunately, this account was not managed by the wealth management
firm. The Vanguard funds in the account had been selected by Jake. While the
asset allocation was not favorable, from an overall portfolio standpoint, this
could be easily fixed. I wondered, however, why the “wealth management” firm
had not provided advice on the 401(k) investments, given the need to consider a
client’s overall asset allocation in order to ensure tax-efficiency and
adherence to a sound investment policy; perhaps they had not been asked to do
so. I explained to the Comptons that the best means to tax-efficiently an
overall investment portfolio is to hold all of their desired asset allocation in
tax-deferred accounts, such as this one (and the nonqualified retirement plans
mentioned above), while holding tax-efficient stock funds in taxable accounts,
all other things being equal.

In
Summary - The Compton’s Portfolio Fiasco. Upon reflection, I wondered what expertise, if any, had
been applied to the construction and management of the investment portfolio.
The overall portfolio did not seem to possess any overall investment strategy.
Investments were recommended that appeared to pay either high commissions
(REITs, oil and gas limited partnerships, VUL policies, EIA) or which incurred
layer after layer of annual fees and costs. Most of the investment portfolio
was structured tax-inefficiently, leading to a huge tax drag on investment
returns. Several of the investments were quite illiquid and would likely take
years to unwind.

From the facts available to me, I
concluded that the wealth management firm had not, in my opinion, delivered
upon their promise of “independent and sound investment advice.” Multiple
conflicts of interest existed. Little or no expertise was applied. Even in the
investment advisory accounts (subject to the fiduciary duties imposed by the
Advisers Act) it did not appear that due consideration was given to avoidance
of high fees and costs. And, under state common law, at least in some states,
fiduciary duties extend to the entirety of the relationship.

The Comptons, in their own words,
“trusted” this “financial professional.” It
was a trust betrayed.

The Comptons became a client of my
own investment advisor firm. Over the first year of our relationship, in which
I am paid a reasonable flat fee, I have been undertaking a restructuring of
their investment portfolio to become much more tax-efficient and to
dramatically reduce the extraordinarily high fees extracted from many of their
investments. In addition, as part of that fee, I have provided advice on their
estate plan, advised on the impact of changes undertaken by Jake’s company to the
nonqualified profit-sharing plans the company offered to him, income tax
planning, and much more. After this first year my annual flat fee will be cut
in half, as much less professional services will be needed by Jake and Missy
Compton, once I spend a year straightening out their current accounts (to the
extent such corrective action is possible).

I wish I could say that the Compton’s
experience was rare. But it is far from a
rare event. Rather, the experience of receiving non-expert, highly
conflicted financial and investment advice results for most Americans today.

Jake and Missy Compton are both very
highly educated. They asked many of the right questions. But, lacking knowledge
of the complex array of financial products their wealth adviser presented to
them, the Comptons were at a substantial disadvantage. They were unaware of the
many conflicts of interest possessed by their wealth manager. And they were
unaware of just how much their wealth manager had been able to extract from
them by way of commissions and other fees.

I have seen similar situations, some
less complex, some more complex, for clients who came to me with $1,000
accounts, and for clients who came to me with total accounts in the tens of
millions of dollars. Regardless of the amount involved, and regardless of the
educational level and “sophistication” of the client, nearly all of these
clients were subject to payment of relatively high fees and costs – and payment
to their “advisor” of fees (often hidden from view) – which were excessive in
nature.

In my nearly 30 years as an estate
planning and tax attorney, and in my nearly 15 years as a fiduciary investment
adviser, I have possessed the opportunity to review hundreds of clients’
investment portfolios. When the clients’ investment portfolios were advised
upon by either broker-dealer firms, by dual registrants (firms and individuals
with both securities broker/dealer licensure and registered investment adviser
licensure), or by insurance agents, the allure of high-fee investment and
insurance products to the registered representative of the broker-dealer firm,
or to the insurance agent, was nearly always too strong to resist. Over 95% of
the time, in my reviews of hundreds of clients’ portfolios, I discerned
high-cost investments, tax-inefficient portfolios, or both.

Economic incentives matter, and they
matter a great deal. When a salesperson has the opportunity to receive much
higher compensation from the sale of one product, compared to another, the allure
of the investment product with the higher compensation (and higher fees to the
client) nearly always win.

These insidious conflicts of
interest cause great harm to the financial and retirement security of our
fellow Americans. The academic research in this area is compelling –
higher-cost investments lead, on average, to lower returns. In fact, there is a
strong negative correlation between the total fees and costs of an investment
product and the returns of that product over the long term, relative to similar
investments:

As stated in a 2011 paper by Michael
Cooper et. al., using data on active and passive U.S. domestic equity funds
(the sample included a total of 13,817 funds within the CRSP Mutual Fund
Database) from 1963 to 2008, the authors observed:

Similar to others, we first show
that fees are an important determinant of fund underperformance – that is,
investors earn low returns on high fee funds, which indicates that investors
are not rewarded through superior performance when purchasing ‘expensive’ funds. We explore a number of hypotheses
to explain the dispersion in fees and find that none adequately explain the
data. Most importantly, there is very little evidence that funds change their
fees over time. In fact the most important determinant of a fund’s fee is the
initial fee that it charges when it enters the market. There is little evidence
that funds reduce their fees following entry by similar funds or that they
raise their fees following large outflows as predicted by the strategic fee
setting hypothesis. We also do not find
evidence that higher fees are associated with proxies for higher service levels
provided to investors.”[3] (Emphasis added.)

In
a recent paper by Vidal et. al.,they
also found that high mutual fund fees predict lower returns. “[We confirm the
negative relation between funds´ before fee performance and the fees they
charge to investors. Second, we find that mutual fund fees are a significant
return predictor for funds, fees are negatively associated with return
predictability. These results are robust to several empirical models and
alternative variables.”[4]

And,
in another recent paper by Sheng-Ching Wu, it was noted that it is not just the
disclosed fees (found in the commissions or redemption fees paid and the annual
expense ratio), but also the transaction costs resulting from turnover of
securities within the fund, that matter. “[F]unds with higher portfolio
turnovers exhibit inferior performance compared with funds having lower
turnovers. Moreover, funds with poor performance exhibit higher portfolio
turnover. The findings support the assumptions that active trading erodes
performance….[5]

America must act now to
substantially reduce this excessive rent seeking by Wall Street via broker’s
sale of expensive investment products to unwitting consumers. And the best way
to do this is to eliminate, or at least substantially reduce, the many
conflicts of interest that drive the extraction of such high rents by brokers
and insurance agents from the portfolios of our fellow citizens.

The high costs of Wall Street’s
services and products not only engender the retirement security of individual
Americans, but also impair the American economy. As the role of finance has
grown ever larger, instead of providing the oil that ensures the American
economic engine churns efficiently, the peddling of expensive investment
products to Americans has led to a sludge that impairs the vitality and
threatens the future of not only our fellow Americans, but of America itself.

The growth of the financial services
industry has grown to an extraordinary proportion of the overall U.S. economy. As
stated in a recent article by Gautam Mukunda appearing in the Harvard Business Review:

In
1970 the finance and insurance industries accounted for 4.2% of U.S. GDP, up
from 2.8% in 1950. By 2012 they represented 6.6%. The story with profits is
similar: In 1970 the profits of the finance and insurance industries were equal
to 24% of the profits of all other sectors combined. In 2013 that number had
grown to 37%, despite the aftereffects of the financial crisis. These figures
actually understate finance’s true dominance, because many nonfinancial firms
have important financial units. The assets of such units began to increase
sharply in the early 1980s. By 2000 they were as large as or larger than
nonfinancial corporations’ tangible assets ….[6]

The result of this excessive rent
extraction by Wall Street is a substantial impediment to the present and future
growth of the growth of the U.S. economy. As Steve Denning recently noted:

The
excessive financialization of the U.S. economy reduces GDP growth by 2% every
year, according to a new study by International Monetary Fund. That’s a massive
drag on the economy–some $320 billion per year. Wall Street has thus become,
not just a moral problem with rampant illegality and outlandish compensation of
executives and traders: Wall Street is a macro-economic problem of the first
order … Throughout history, periods of excessive financialization have
coincided with periods of national economic setbacks, such as Spain in the 14th
century, The Netherlands in the late 18th century and Britain in the late 19th
and early 20th centuries. The focus by elites on “making money out of money”
rather than making real goods and services has led to wealth for the few, and
overall national economic decline. ‘In a financialized economy, the financial
tail is wagging the economic dog.’[7]

Wall Street’s lack of legal and
ethical constraints have been opined by many as the root cause of the financial
crisis of 2008-9 and the resulting recession in the United States, from which
we still have not fully recovered. In fact, the failure of the U.S. economy to
recover may partly be due to the excessive rent seeking Wall Street undertakes.

As Jack Bogle, founder of Vanguard,
observed: “Self-interest, unchecked, is a powerful force, but a force that, if
it is to protect the interests of the community of all of our citizens, must
ultimately be checked by society. The recent crisis—which has been called ‘a
crisis of ethic proportions’ – makes it clear how serious that damage can
become.”[8]

and
Disclosure Alone; SIFMA’s and FINRA’s “Best Interests” Proposals As Misleading and
Weak

Is America the greatest country? Not
by many measures, when compared to other developed nations of the world. Yet,
with the concerted effort of entrepreneurs, innovators, educators, and the
providers of monetary and human capital, tempered properly by logical and
efficient standards of conduct imposed by necessary government regulation so as
to constrain excessive rent seeking and to deter improper conduct, I believe
America can once again become the greatest country.

Essential to these efforts is the
need to better ensure the future retirement security of all Americans. At the
present time trust in our system of financial services remains at a historical
low. Americans in need of financial advice are reluctant to seek out such
advice, given the presence of so many conflicts of interest from purveyors of
investment products.

While SIFMA, FSI and other
representatives of many of the broker-dealer firms have referred to the DOL
rule as “unworkable,” the reality is that the current conflict-ridden
product-sales business model of Wall Street does not desire to see its high
extraction of rents from individual Americans terminated.

Yet, the delivery of investment
advice to small business owners and large business owners (plan sponsors), and
to individual Americans (whatever the size of their account), is currently
undertaken under a fiduciary standard of conduct. In fact, independent
registered investment advisory firms and their investment advisers
representatives deliver fiduciary investment advice to millions of Americans at
the present time, under a fiduciary business model.

The current sad state of affairs is
untenable. If Americans are not aided by fiduciary advice, and if the continued
high extraction of rents occurs by Wall Street from the hard-earned retirement
savings of millions of Americans, then federal, state and local governments
will be all called upon to provide increased support for individual Americans,
especially those in retirement, who possess far too less in their investment
portfolios in the future. This will further create a burden upon governments,
resulting in pressure to raise taxes. This in turn would further constrain
future U.S. economic growth.

Every effort should be undertaken to
better arm our individual Americans with fiduciary investment advice. The DOL
proposal to expand the application of fiduciary status is an outstanding part
of the solution required to ensure a better future not just for our fellow
Americans, but for America itself.

Generally,
“suitability” refers to the obligation of a full service broker to recommend to
a customer only those securities that match the customer’s financial needs and
goals. There are essentially two major dimensions of the suitability
obligation: (1) “reasonable basis” or “know your security” suitability that
focuses on the characteristics of the recommended security and requires a minimal
degree of product due diligence prior to the sale of the security to any
client; and (2) “customer-specific” or “know your customer” suitability, which
focuses on ascertaining the financial objectives, needs, and other
circumstances of the particular customer before recommending investment
products to that customer. A third dimension of suitability guards against
churning.

In
simplistic terms, the “reasonable basis” aspect of suitability prohibits one
from selling investments which are high explosives, as brokers cannot sell
investments are “unsuitable” for any investor, regardless of the
investor’s wealth, willingness to bear risk, age, or other individual
characteristics. This might, for example, present a barrier to the sale of
unregistered securities with no operations, assets or earnings. However, under
“reasonable basis suitability” the sale of high-risk Roman candles and other
firecrackers might be permitted as a portion of some investors’ portfolios.

However, the
“customer-specific” aspect of suitability prevents the sale of Roman candles
and firecrackers to certain particular investors who might be unable to bear
the risks of certain investments. It prevents brokers from selling by
high-risk, illiquid, and/or complex securities to elderly, inexperienced or
unsophisticated customers who do not understand the risks of such investments.

While the
suitability obligation was for a time imposed directly[10] by the
U.S. Securities and Exchange Commission (SEC) upon brokers who were not a
member of a self-regulatory organization (SRO), the SEC’s regulation was
rescinded in 1983 when all broker-dealers were required to be a member of an
SRO. Hence, the source for the suitability obligation is now found exclusively
in the rules of the National Association of Securities Dealers (NASD), renamed
as the Financial Services Regulatory Authority (FINRA), and in FINRA Rule 2111.[11]

The Exchange
Act directs that FINRA’s rules be “designed to prevent fraudulent and manipulative
acts and practices.” FINRA also imposes on its members the duty to “observe
high standards of commercial honor and just and equitable principles of trade.”[12] This
duty has been interpreted by FINRA to he prohibit registered firms from making
false, misleading, or exaggerated statements or claims or omitting material
information in all advertisements and sales literature directed to the public.

At its
core, when it applies to the provision of advice, the suitability doctrine
actually lessens the duty of due care.
In the context of advisory recommendations, suitability serves to confine the
duties of broker-dealers and their registered representatives to their
customers to below that of the broad common law duty of due care.

By way of
explanation, with the early 20th Century rise of the concept of the duty of due
care, and the commencement of actions for breach of one’s duty of due care (via
the accelerated development during of the negligence doctrine during such time),
broker-dealers sought a way to ensure they would not be held liable under the
standard of negligence. After all, “[t]o the extent that investment
transactions are about shifting risk to the investor, whether from the
intermediary, an issuer, or a third party, the mere risk that a customer may
lose all or part of its investment cannot, in and of itself, be sufficient
justification for imposing liability on a financial intermediary.”[13] This
appears to be a valid view as to the duty of care that should be imposed upon a
broker-dealer. However, this low duty of care is only appropriate if the
broker-dealer is only providing only trade execution services to the customer.

In essence,
the suitability standard was originally designed solely to protect brokers who
provided trade execution services from breaches of the duty of due care
applicable to all product sellers, given the inherent risks of investing in
individual securities. Yet, as broker’s services have expanded, the suitability
standard has inappropriately been applied to broker’s other services, including
those services that are clearly of an advisory nature.

In contrast
to the individual stocks and bonds for which brokers mostly executed
transactions in the 1930’s, currently brokers often recommend mutual funds and
other pooled investment vehicles (including but not limited to unit investment
trusts, ETFs, variable annuity subaccounts and equity indexed annuities).
Indeed, mutual fund sales exploded a thousand-fold shortly following the SEC’s
abolition of all fixed commission rates effective May 1, 1975. But, along the
way, no longer were broker-dealers just performing trade execution services,
but they were, in fact, providing advice through their recommendation of
investment managers. Yet, inexplicably, the SEC and FINRA permitted the
suitability doctrine to be extended to incorporate broker-dealers’
recommendations of the managers of pooled investment vehicles. As a result,
brokers operate with a free hand today when providing advice on mutual fund
selection. Brokers, as a result of the incorrect expansion of the application
of the suitability doctrine, are unburdened by the duty of nearly every other
person in the United States with respect to their advisory activities, which,
at a minimum, for other providers of advice require adherence to the duty of
due care of a reasonable person.

Suitability’s
abrogation of the duty of care means that suitability lacks teeth when
investment advice is provided.

·Suitability
does not generally impose upon broker-dealers any obligation to
recommend a “good” product over a “bad” one.

·Suitability
does not impose upon brokers and their registered representatives a duty
to recommend a less expensive product over an expensive product, even where the
product’s composition and risk characteristics are almost identical, and even
though substantial academic research concludes that higher-cost products return
less to investors than similar lower-cost products over longer periods of time.

·Suitability
does not require brokers and their registered representatives to
recommend products that meet a client’s objectives for tax-efficient and
prudently structured investment portfolios.

·Suitability
does not require brokers and their registered representatives to avoid
conflicts of interest, nor to properly manage the unavoidable conflicts of
interest that remain to keep the clients’ best interests paramount at all
times.

In summary,
the suitability standard permits the conflict-ridden sale of highly expensive,
tax-inefficient and risky investment products, leaving the customer with little
or no redress.

Suitability
remains a “nebulous and amorphous with respect to its content and parameters.”[14] It
essentially imposes upon broker-dealers only the responsibility to not permit
their customers to “self-destruct.”

In summary,
the “suitability” standard was not originally designed to, nor should it be
permitted to, apply to the provision of investment advice. Suitability
abrogates the all-important duty of care required of nearly every other
provider of services.

In essence,
suitability is a shield that protects brokers, not investors. It is such a low
standard of conduct that, even when surrounded by a multitude of other rules
and an enforcement regime, it is but a loud dog that lacks any teeth.

In recent years various proposals
have been advanced by Wall Street to merely enhance the suitability doctrine.
These suggestions include adding certain mandated disclosures, usually of a
casual nature (such as “our interests may not be aligned with yours”). Wall
Street advances these proposals in hopes of defeating the imposition of
fiduciary status on brokers who provide investment advice. Yet, as Wall Street
is fully aware, disclosures are seldom read by consumers, and even when read they
are rarely understood. While disclosure is said to be a key component of the
federal securities laws, the Investment Advisers Act of 1940 and ERISA were
enacted, subsequent to the regulations imposed under the ’33 Securities Act and
the ’34 Securities Exchange Act (and the ’37 Maloney Act amendments thereto),
in order to impose fiduciary standards upon those who provide investment
counsel to our fellow Americans. In essence, Congress recognized that
disclosure was insufficient to safeguard the interests of investors, and hence
public policy dictated that fiduciary obligations be imposed.

While
federal and state securities laws and regulations have imposed certain
disclosure obligations upon brokers, such disclosures are inherently
ineffective as a consumer protection measure, for a variety of reasons. Indeed,
the necessity for the rise of fiduciary standards of conduct throughout several
centuries of the law reflects the realization, over the centuries, that
disclosures possess limited impact as a means of consumer protection. If
disclosures were a sufficient means of protection, then the common law would
have never created the fiduciary standard.

Even in the 1930’s, the perception
existed that disclosures would prove to be inadequate as a means of investor
protection. As stated early on by Professor Schwarcz:

Analysis of the tension between investor understanding
and complexity remains scant. During the debate over the original enactment of
the federal securities laws, Congress did not focus on the ability of investors
to understand disclosure of complex transactions. Although scholars assumed
that ordinary investors would not have that ability, they anticipated that
sophisticated market intermediaries – such as brokers, bankers, investment
advisers, publishers of investment advisory literature, and even lawyers -
would help filter the information down to investors.[15]

Academic
research exploring the nature of individual investors’ behavioral biases, as a
limitation on the efficacy of disclosure and consent, also strongly suggests
that client waivers of fiduciary duties are not effectively made. In a paper
exploring the limitations of disclosure on clients of stockbrokers, Professor
Robert Prentice explained several behavioral biases which combine to render
disclosures ineffective: (1) Bounded Rationality and Rational Ignorance; (2)
Overoptimism and Overconfidence; (3) The False Consensus Effect; (4)
Insensitivity to the Source of Information; (5) Oral Versus Written
Communications; (6) Anchoring; and (7) Other Heuristics and Biases.
Moreover, as Professor Prentice observed: “Securities professionals are well
aware of this tendency of investors, even sophisticated investors, and take
advantage of it.”[16] Much
other academic research into the behavioral biases faced by individual
investors has been undertaken, in demonstrating the substantial challenges
faced by individual investors in dealing with those providing financial advice
in a conflict of interest situation.

Behavioral
biases also negate the abilities of “do-it-yourself” investors. As shown in
DALBAR, Inc.’s 2009 “Quantitative Analysis of Investor Behavior,” most individual
investors underperform benchmark indices by a wide margin, far exceeding the
average total fees and costs of pooled investment vehicles. A growing body of
academic research into the behavioral biases of investors reveals substantial
obstacles individual investors must overcome in order to make informed investment
decisions,[17]
and reveal the inability of individual investors to contract for their own
protections.[18]

Financial
advisors also utilize clients’ behavioral biases to their own advantage, if not
restricted by appropriate rules of conduct. As stated by Professor Prentice,
“instead of leading investors away from their behavioral biases, financial
professionals may prey upon investors’ behavioral quirks … Having placed their
trust in their brokers, investors may give them substantial leeway, opening the
door to opportunistic behavior by brokers, who may steer investors toward poor
or inappropriate investments.”[19] (as was
the case with the Comptons, and as is the case with tens of millions of other
Americans.)

Practice
management consultants train financial and investment advisors to take
advantage of the behavioral biases of consumers. In fact, I have been so
trained. The instruction involves actions to build a relationship of trust and
confidence with the client first, far before any discussion of the service to
be provided or the fees for such services. It is well known among marketing
consultants that once a relationship of trust and confidence is established,
clients and customers will agree to most anything in reliance upon the bond of
trust that has been formed.

The SEC’s
emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities
Acts on enhanced disclosures, results from the myth that investors carefully
peruse the details of disclosure documents that regulation delivers.
However, under the scrutinizing lens of stark reality, this picture gives way
to an image a vast majority of investors who are unable, due to behavioral
biases and lack of knowledge of our complicated financial markets, to undertake
sound investment decision-making. As stated by Professor (and former SEC
Commissioner) Troy A. Paredes:

The federal securities laws generally assume that
investors and other capital market participants are perfectly rational, from
which it follows that more disclosure is always better than less. However,
investors are not perfectly rational. Herbert Simon was among the first to
point out that people are boundedly rational, and numerous studies have since
supported Simon’s claim. Simon recognized that people have limited cognitive
abilities to process information. As a result, people tend to economize on
cognitive effort when making decisions by adopting heuristics that simplify
complicated tasks. In Simon’s terms, when faced with complicated tasks, people
tend to ‘satisfice’ rather than ‘optimize,’ and might fail to search and
process certain information.[20]

In reality,
disclosures, while important, possess limited ability to protect investors,
particularly in today’s complex financial world. As Professor Daylian Cain has often
remarked, “The saying that ‘sunlight is the best disinfectant’ is just not
true.”

The insufficiency of disclosure as a
means of investor protection was highlighted at the Fiduciary Forum, held in
September 2010 in D.C. and co-sponsored by the Committee for the Fiduciary
Standard, CFP Board, NAPFA, FSI, and FPA. Two of the professors presenting at
that conference also have written extensively regarding the inherent limits of
disclosure as a means of consumer protection.

In a paper
by Professors Daylian Cain, George Loewenstein, and Don Moore, "The Dirt
on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest,"
they challenged the belief of some that disclosure can be a reliable and
effective remedy for the problems cause by conflicts of interest, and
concluded:

In sum, we have shown that disclosure cannot be assumed
to protect advice recipients from the dangers posed by conflicts of interest.
Disclosure can fail because it (1) gives advisors strategic reason and moral
license to further exaggerate their advice, and (2) the disclosure may not lead
to sufficient discounting to counteract this effect. The evidence presented
here casts doubt on the effectiveness of disclosure as a solution to the
problems created by conflicts of interest. When possible, the more lasting
solution to these problems is to eliminate the conflicts of interest. As
Surowiecki (2000) commented in an article in the New Yorker dealing specifically with conflicts of interest in
finance, ‘transparency is well and good, but accuracy and objectivity are even
better. Wall Street doesn’t have to keep confessing its sins. It just has to
stop committing them.’[[21]

In another paper
co-authored by Professor Cain, he opined:

Conflicts of interest can lead experts to
give biased and corrupt advice. Although disclosure is often proposed as a
potential solution to these problems, we show that it can have perverse
effects. First, people generally do not discount advice from biased advisors as
much as they should, even when advisors' conflicts of interest are honestly
disclosed. Second, disclosure can increase the bias in advice because it leads
advisors to feel morally licensed and strategically encouraged to exaggerate
their advice even further. This means that while disclosure may
[insufficiently] warn an audience to discount an expert-opinion, disclosure
might also lead the expert to alter the opinion offered and alter it in such a
way as to overcompensate for any discounting that might occur. As a result,
disclosure may fail to solve the problems created by conflicts of interest and
it may sometimes even make matters worse.[22]

The dimensions of the
biases of advisors, when attempting to deal with non-avoided conflicts of
interest, was revealed in a paper citing earlier research by Professor Cain and
others, as Professor Antonia Argandoña observed:

As a rule, we tend to assume that
competent, independent, well trained and prudent professionals will be capable
of making the right decision, even in conflict of interest situations, and
therefore that the real problem is how to prevent conscious and voluntary
decisions to allow one’s own interests (or those of third parties) to prevail
over the legitimate interests of the principal – usually by counterbalancing
the incentives to act wrongly, as we assume that the agents are rational and
make their decisions by comparing the costs and benefits of the various
alternatives.

Beyond that problem, however, there are
clear, unconscious and unintended biases in the way agents gather, process and
analyze information and reach decisions that make it particularly difficult for
them to remain objective in these cases, because the biases are particularly
difficult to avoid. It has been found that,

·The agents tend to see themselves as competent, moral individuals
who deserve recognition.

·They see themselves as being more honest, trustworthy, just and objective
than others.

·Unconsciously, they shut out any information that could undermine
the image they have of themselves – and they are unaware of doing so.

·Also unconsciously, they are influenced by the roles they assume,
so that their preference for a particular outcome ratifies their sense of
justice in the way they interpret situations.

·Often, their notion of justice is biased in their own favor. For
example, in experiments in which two opposed parties’ concept of fairness is
questioned, both tend to consider precisely what favors them personally, even
if disproportionately, to be the most fair.

·The agents are selective when it comes to assessing evidence; they
are more likely to accept evidence that supports their desired conclusion, and
tend to value it uncritically. If evidence contradicts their desired
conclusion, they tend to ignore it or examine it much more critically.

·When they know that they are going to be judged by their
decisions, they tend to try to adapt their behavior to what they think the
audience expects or wants from them.

·The agents tend to attribute to others the biases that they refuse
to see in themselves; for example, a researcher will tend to question the
motives and integrity of another researcher who reaches conclusions that differ
from her own.

·Generally speaking, the agents tend to give far more importance to
other people’s predispositions and circumstances than to their own.

For all these reasons, agents, groups and
organizations believe that they are capable of identifying and resisting the
temptations arising from their own interests (or from their wish to promote the
interests of others), when the evidence indicates that those capabilities are
limited and tend to be unconsciously biased.[23]

In essence,
disclosure – while important - has limited efficacy in the delivery of
financial services to clients. Making disclosures “simpler” does not solve the
problem of their effectiveness, either. As stated by Professor Ripken:

[E]ven if we could purge disclosure documents of
legaleze and make them easier to read, we are still faced with the problem of
cognitive and behavioral biases and constraints that prevent the accurate processing
of information and risk. As discussed previously, information overload,
excessive confidence in one’s own judgment, overoptimism, and confirmation
biases can undermine the effectiveness of disclosure in communicating relevant
information to investors. Disclosure may not protect investors if these
cognitive biases inhibit them from rationally incorporating the disclosed
information into their investment decisions. No matter how much we do to make
disclosure more meaningful and accessible to investors, it will still be
difficult for people to overcome their bounded rationality. The disclosure of
more information alone cannot cure investors of the psychological constraints
that may lead them to ignore or misuse the information. If investors are
overloaded, more information may simply make matters worse by causing investors
to be distracted and miss the most important aspects of the disclosure … The
bottom line is that there is ‘doubt that disclosure is the optimal regulatory
strategy if most investors suffer from cognitive biases’ … While disclosure has
its place in a well-functioning securities market, the direct, substantive
regulation of conduct may be a more effective method of deterring fraudulent
and unethical practices.[24]

The
inability of disclosures to overcome the substantial economic self-interest
that brokers possess when selling products can also be understood through
judicial prose. If disclosures were sufficient, there would be no need for the
fiduciary obligation. But disclosure, being insufficient as a means of consumer
protection, requires that individual investors seeking investment advice be served
under a bona fide fiduciary standard. In Bayer v. Beran, 49 N.Y.S.2d 2,
Mr. Justice Shientag observed:

The fiduciary has two paramount obligations:
responsibility and loyalty. * * * They lie at the very foundation of our whole
system of free private enterprise and are as fresh and significant today as
when they were formulated decades ago. * * * While there is a high moral
purpose implicit in this transcendent fiduciary principle of undivided loyalty,
it has back of it a profound understanding of human nature and of its
frailties. It actually accomplishes a practical, beneficent purpose. It tends
to prevent a clouded conception of fidelity that blurs the vision. It preserves
the free exercise of judgment uncontaminated by the dross of divided allegiance
or self-interest. It prevents the operation of an influence that may be
indirect but that is all the more potent for that reason.[25]

In summary, disclosures are not the
answer. If disclosures were sufficient as a means of protecting consumers in a
relationship of trust and confidence with another, then the fiduciary standard
would have never arisen under English law, nor would it have been transported
into American law. ERISA properly reflects the reality that disclosures are
insufficient and that a strict fiduciary standard must be applied to protect
individual investors and plan sponsors from transgressions by far more
knowledgeable advisers.

At its very core, the fiduciary
standard is a constraint upon greed. The fiduciary standard of conduct imposes
important duties upon fiduciary advisors in order to protect the consumer of
advice. As the U.S. Supreme Court has observed: “[T]he primary function of the
fiduciary duty is to constrain the exercise of discretionary powers which are
controlled by no other specific duty imposed by the trust instrument or the
legal regime. If the fiduciary duty applied to nothing more than activities
already controlled by other specific legal duties, it would serve no purpose.”[26]

While
suitability is a very low standard of conduct, the fiduciary standard of
conduct is well known as the “highest standard under the law.”

While there have been many judicial elicitations of the
fiduciary standard, including Justice Benjamin Cardozo’s lofty early 20th
Century elaboration, a relatively recent and concise recitation of the
fiduciary principle can be found in dictum within the 1998 English (U.K.) case
of Bristol and West Building Society v. Matthew, in which Lord Millet
undertook what has been described as a “masterful survey” of the fiduciary
principle:

A fiduciary
is someone who has undertaken to act for and on behalf of another in a
particular matter in circumstances which give rise to a relationship of trust
and confidence. The distinguishing obligation of a fiduciary is the obligation
of loyalty. The principle is entitled to the single-minded loyalty of his
fiduciary. This core liability has several facets. A fiduciary must act in good
faith; he must not place himself in a position where his duty and his interest
may conflict; he may not act for his own benefit or the benefit of a third
person without the informed consent of his principal. This is not intended to
be an exhaustive list, but it is sufficient to indicate the nature of the
fiduciary obligations. They are the defining characteristics of a fiduciary.[27]

In the U.S.,
the “triad” of fiduciary duties is most commonly referred to as the duties of
due care, good faith and loyalty. But other fiduciary duties are said to exist,
including but not limited to the “duty of obedience” and the “duty of
confidentiality.”

A further
elicitation of fiduciary duties can be discerned from English law, from which
the U.S. system of jurisprudence was initially derived. Under English law, it
is reasonably well established that fiduciary status gives rise to five
principal duties:

(1) the “no
conflict” principle preventing a fiduciary placing himself in a position where
his own interests conflict or may conflict with those of his client or
beneficiary;

(2) the “no
profit” principle which requires a fiduciary not to profit from his position at
the expense of his client or beneficiary;

(3) the
“undivided loyalty” principle which requires undivided loyalty from a fiduciary
to his client or beneficiary;

(4) the
“duty of confidentiality” which prohibits the fiduciary from using information
obtained in confidence from his client or beneficiary other than for the
benefit of that client or beneficiary; and

(5) the
“duty of due care,” to act with reasonable diligence and with requisite
knowledge, experience and attention.

When one is
engaged as a fiduciary, the fiduciary steps into the shoes of the client, in
order to act on the client’s behalf. As Professor Arthur Laby observed: “What
generally sets the fiduciary apart from other agents or service providers is a
core duty, when acting on the principal’s behalf, to adopt the objectives or
ends of the principal as the fiduciary’s own.”[28]

In fiduciary
relationships, a transfer of power occurs – if not the actual transfer of
assets (as may occur in a trust or custody relationship), then the transfer of
power through the taking, by the client, of the fiduciary’s advice and counsel
(as may occur in a lawyer-client or investment adviser-client relationship).

The client
permits this close, confidential relationship to exist in recognition that the
expertise of the fiduciary, brought to bear for the benefit of the client, can
lead to much more positive outcomes.

But such expertise,
if improperly applied, can be used to take advantage of the client. The
fiduciary, as a expert, possess a much greater knowledge of investments,
portfolio management, etc. Also, the client’s guard is down; due to a variety
of behavioral biases, client consent to action by the fiduciary is easily
secured.

Hence, U.S. fiduciary
law applicable to investment advisers guards against the abuse of the consumer through
its "no conflict" rule. Reflective of English law’s “no benefit” and
“no conflict” principles, the Restatement (Third) of Agency (all agents are, to
a degree, fiduciaries) dictates that the duty of loyalty is a duty to not
obtain a benefit through actions taken for the principal (client) or to
otherwise benefit through use of the fiduciary’s position.[29]

The “no
conflict” rule has nothing to do with good or bad motive. The U.S. Supreme
Court, in discussing conflicts of interest, stated:

The reason of the rule inhibiting a party who occupies
confidential and fiduciary relations toward another from assuming antagonistic
positions to his principal in matters involving the subject matter of the trust
is sometimes said to rest in a sound public policy, but it also is justified in
a recognition of the authoritative declaration that no man can serve two
masters; and considering that human nature must be dealt with, the rule does
not stop with actual violations of such trust relations, but includes within
its purpose the removal of any temptation to violate them ....[30]

And, as the
U.S. Supreme Court said a hundred years ago, the law “acts not on the
possibility, that, in some cases the sense of duty may prevail over the motive
of self-interest, but it provides against the probability in many cases, and
the danger in all cases, that the dictates of self-interest will exercise a
predominant influence, and supersede that of duty.”[31]

And, in the
seminal case addressing the fiduciary duties of investment advisers under the
Investment Advisers Act of 1940, the U.S. Supreme Court observed:

This Court, in discussing conflicts of interest, has
said: ‘The reason of the rule inhibiting a party who occupies confidential and
fiduciary relations toward another from assuming antagonistic positions to his
principal in matters involving the subject matter of the trust is sometimes
said to rest in a sound public policy, but it also is justified in a
recognition of the authoritative declaration that no man can serve two masters;
and considering that human nature must be dealt with, the rule does not stop
with actual violations of such trust relations, but includes within its purpose
the removal of any temptation to violate them ….’[32]

Or, as an
eloquent Tennessee jurist put it before the Civil War, the doctrine “has its
foundation, not so much in the commission of actual fraud, but in that profound
knowledge of the human heart which dictated that hallowed petition, ‘Lead us
not into temptation, but deliver us from evil,’ and that caused the
announcement of the infallible truth, that ‘a man cannot serve two masters.’”[33]

The stark
difference between arms-length and fiduciary relationships is also found in the
treatment of the doctrines of waiver and estoppel. The DOL’s proposed BIC
exemption correctly notes this distinction by prohibiting disclaimer or waiver
of the adviser’s fiduciary obligations.

In
arms-length relationship consent by a customer to proceed, when a conflict of
interest is present, is generally permitted. Caveat emptor (“let the buyer
beware”) applies to such merchandiser-customer relationships. The customer is
not represented by the merchandiser but is rather in an adverse relationship -
that of seller and purchaser.

In such
instances, it is a fundamental principle of the common law that volenti non fit injuria – to one who is
willing, no wrong is done. Customer consent to the transaction generally gives
rise to estoppel – i.e., the customer cannot later state that he or she can
escape from the transaction because a conflict of interest was present, or because
full awareness of the ramifications of the conflict of interest were absent.
The customer, in such instances, bears the duty of negotiating a fair bargain.
The law permits customers, in arms-length relationships, to enter into “dumb
bargains.” Generally, jurists will not set aside unfair bargains unless fraud,
misrepresentation, mutual mistake of fact exists or unless the contract is so
unjust and burdensome that it is deemed unconscionable.

But the
fiduciary relationship is altogether different. The entrustor (client) and
fiduciary actor have formed a relationship based upon trust and confidence. In
such a form of relationship, the law guards against the fiduciary taking
advantage of such trust. As a result, judicial scrutiny of aspects of the
relationship occurs with a sharp eye toward any transgressions that might be
committed by the fiduciary.

Hence, mere
consent by a client in writing to a breach of the fiduciary obligation is not,
in itself, sufficient to create waiver or estoppel. If this were the case,
fiduciary obligations – even core obligations of the fiduciary – would be
easily subject to waiver. Instead, to create an estoppel situation, preventing
the client from later challenging the validity of the transaction that
occurred, the fiduciary is required to undertake a series of steps:

First,
disclosure of all material facts to the client must occur. [For some
commentators on the fiduciary obligations of investment advisers, this is all
that is required. Often this erroneous conclusion is derived from
misinterpretations of the landmark decision of
SEC v. Capital Gains Research Bureau.][34]

Second, the
disclosure must be affirmatively made and timely undertaken. In a fiduciary
relationship, the client’s “duty of inquiry” and the client’s “duty to read”
are limited; the burden of ensuring disclosure is received is largely borne by
the fiduciary. Disclosure must also occur in advance of the contemplated
transaction. For example, receipt of a prospectus following a transaction is
insufficient, as it does not constitute timely disclosure.

Third, the
disclosure must lead to the client’s understanding. The fiduciary must be aware
of the client’s capacity to understand, and match the extent and form of the
disclosure to the client’s knowledge base and cognitive abilities.

Fourth, the
informed consent of the client must be affirmatively secured. Silence is not
consent. Consent is not obtained through coercion nor sales pressure.

Fifth, at
all times, the transaction must be substantively fair to the client. If an
alternative exists which would result in a more favorable outcome to the
client, this would be a material fact which would be required to be disclosed,
and a client who truly understands the situation would likely never
gratuitously make a gift to the advisor where the client would be, in essence,
harmed.[35]

These
requirements of the common law – derived from judicial decisions over hundreds
of years – have found their way into our statutes. For example, ERISA’s
exclusive benefit rule unyieldingly commands employee benefit plan fiduciaries
to discharge their duties with respect to a plan solely in the interest of the
plan’s participants and for the exclusive purpose of providing benefits to them
and their beneficiaries. And the Investment Advisers Act of 1940 was widely
known to impose fiduciary duties upon investment advisers from its very
inception, and it contains an important provision that prevents waiver by the
client of the investment adviser’s duties to that client.

As one
examines the foregoing requirements, it is important to realize that disclosure
is neither a fiduciary duty nor a cure (without much more) to the breach of
one’s fiduciary obligations. In other words, it must be understood that, quite
frankly, there exists fiduciary duty of disclosure. While disclosure may be
imposed by other law or regulation, or by contractual obligations created
between the parties, disclosure is not, itself, a core fiduciary obligation
found in the common law.

Rather,
fiduciaries owe the obligation to their client to not be in a position where
there is a substantial possibility of conflict between self-interest and duty. This
is called the “no-conflict” rule, derived from English law. Fiduciaries also
possess the obligation not to derive unauthorized profits from the fiduciary
position. This is called the “no profit” rule, also derived from English law.

While there
is no fiduciary duty of disclosure, questions of disclosure are often central
in the jurisprudence discussing fiduciary law, as many cases involve claims for
breach of the fiduciary duty due to the presence of a conflict of interest. In
essence, a breach of fiduciary obligation – either the obligation not to be in
a position of conflict of interest and the duty to not make unauthorized
profits – may be averted or cured by the informed consent of the client
(provided all material information is disclosed to the client, the adviser
reasonably expects client understanding to result given all of the facts and
circumstances, the informed consent of the client is affirmatively secured, and
the transaction remains in all circumstances substantially fair to the client).

In essence,
asking a client to consent to a conflict of interest by the fiduciary is
requesting that the client waive the no conflict rule, the no profit rule, or
both rules. Again, clients would only do so in circumstances where the client
is not harmed. It would be difficult to believe that client is so gratuitous to
his or her investment adviser that the client would incur a detriment, beyond
reasonable compensation previously agreed to, in order to provide the adviser
with more lucre or other benefits.

Hence,
disclosure, alone, is not a cure. And disclosure is only one of the five
important requirements, all of which must be met, for a client’s waiver of a
fiduciary obligation to be valid.

As the DOL
and SEC further consider the imposition of fiduciary obligations upon those
providing advice to retirement plan sponsors, retirement plan participants, IRA
account holders, and more broadly to any American receiving personalized
investment advice, let us first understand that the fiduciary's obligation
includes, at its core, the obligation to not put herself or himself into a
situation which is in conflict with the client. And, since some conflicts of
interest are unavoidable, when such conflicts do occur this series of five
important requirements must be met to properly manage the conflict.

The core of
fiduciary law requires nothing less. Nor should the DOL and the SEC.

“Goldman's arguments in this respect are Orwellian.
Words such as ‘honesty,’ ‘integrity,’ and ‘fair dealing’ apparently [in Goldman’s
eyes] do not mean what they say; [Goldman says] they do not set standards; they
are mere shibboleths. If Goldman's claim of ‘honesty’ and ‘integrity’ are
simply puffery, the world of finance may be in more trouble than we recognize.” – Judge
Paul Crotty,

In just the
past couple of months, SIFMA has advanced a “best interests” standard of
conduct, as an amendment to FINRA’s suitability obligation.[36] FINRA,
in its July 17, 2015 comment letter to the U.S. Department of Labor regarding
the Conflict of Interest rule proposal and the exemptions relating thereto,
also proposes a “best interests” standard. Upon close examination it is
apparent that the rhetoric emanating from SIFMA and broker-dealer firms
regarding the “best interests” proposal, and the proposals themselves, are but eleventh-hour
attempts to defeat the U.S. Department of Labor’s proposed Conflict of Interest
Rule. SIFMA and FINRA, by these proposals, seek to deny the imposition of
fiduciary status upon those who provide investment advice to retirement plans
and retirement accounts, and in so doing seek to preserve a
product-sales-driven “caveat emptor” relationship which is inappropriate for
the delivery of personal investment advice. It is also apparent that the term
“best interests” should not be utilized by either SIFMA or FINRA at all, given
its understanding for centuries in the context of delivery of trusted advice to
mean adherence to the fiduciary duty of loyalty.

For example,
Richard Ketchum, Chairman and CEO of FINRA, recently summarized the protections
for customers of brokers, stating that these protections “show that depictions
of the present environment as providing ‘caveat emptor’ freedom to
broker-dealers to place investors in any investment that benefits the firm
financially with no disclosure of their financial incentives or the risks of
the product, are simply not true.”[37]
However, Mr. Ketchum’s characterization of broker-dealer firms’ customers as
not being subject to the ancient principle of ‘caveat emptor’[38] is
largely incorrect; by his statement he obfuscates the sales origins and present
reality of today’s broker-customer relationships. Additionally, while certain
disclosure obligations are imposed on broker-dealers, these disclosures are
often casual in nature, do not require the adviser to ensure client
understanding of the conflicts of interest and their ramifications, and do not
require that any proposed transaction wherein a conflict of interest exist
remain (even with disclosure and informed consent) substantively fair to the
client.

I
would observe FINRA’s recent support of a new “best interests” standard recently
advanced by SIFMA,[39]
the broker-dealer lobbying organization, grounded upon a weak suitability
obligation accompanied by somewhat enhanced casual disclosures of additional
information to investors, continues 75 years of FINRA’s failure to advance
standards to the highest levels, as envisioned by Senator Maloney and others,
and fails to protect individual investors. FINRA’s stated opposition to the
Department of Labor’s Conflict of Interest rule proposal is further evidence
that FINRA serves only the interests of its broker-dealer members, and fails to
adequately protect the investing public. Rather than embrace any changes to
FINRA’s suitability obligation by means of a misleading and wholly ineffective
“best interests” standard, I would suggest that FINRA should be disbanded and
its quasi-government oversight functions of the market conduct of broker-dealer
firms and their registered representatives should be returned to federal and
state agencies.

SIFMA has proposed that its “best
interests” standard be adopted in lieu of the imposition of fiduciary standards
of conduct upon brokers who provide investment advice. Yet, SIFMA’s proposed
“best interests” standard is also a far cry from the significantly enhanced protections
afforded to consumers by a bona fide fiduciary standard of conduct, as proposed
by the U.S. Department of Labor in its “Conflict of Interest” rule proposal
(April 2015) and as found in existing common law applicable to those in
relationships of trust and confidence with their clients. SIFMA’s proposed “best
interests” standard would – if enacted – deny consumers, in today’s complex
financial world, important protections by keeping individual investors in the
situation where “caveat emptor” remains the rule for investors, even for those
in relationships of trust and confidence with individuals and firms who provide
personalized investment advice.

SIFMA’s new “best interests”
standard is also inherently misleading and deceptive, as the term “best
interests” is commonly understood by consumers to mean that the advisor is
acting on behalf of the consumer/investor, keeping the consumer’s interests
paramount at all times.[40]

FINRA’s July 17, 2015 comment letter
to the DOL also outlines its version of a “best interests” standard. This
proposal demonstrates FINRA’s continued inability to substantially raise the
standards of conduct of brokers to the highest levels, as contemplated by
Senator Maloney and others at the time of FINRA’s inception (when it was called
the NASD). FINRA’s willingness to continue to protect brokers, under the shield
of an inherently weak suitability standard (whether or not “enhanced” by its
“best interests” proposal), also confirms the necessity of the U.S. Department
of Labor moving forward to impose fiduciary status upon investment advisers to ERISA-governed
retirement plans and to IRAs, as contemplated by the proposed rule.

In the table below I summarize the
flaws in SIFMA’s and FINRA’s recent “best interests” proposals and demonstrate
why SIFMA’s proposed changes to FINRA’s suitability rule do not come even close
to the protections provided by the fiduciary standard:

The brokerage
firm, and, through the firm, various product manufacturers. The financial
representative functions as a “seller’s representative” with no substantial allegiance
required to the purchaser (customer).

The brokerage
firm, and, through the firm, various product manufacturers. The financial
representative functions as a “seller’s representative” with no substantial allegiance
required to the purchaser (customer).

Does a duty exist upon the representative
to clearly and fully disclose all compensation received by the person
providing advice, and by his/her firm?

Yes.

No. While annual
disclosure occurs of “a good faith summary of the investment-related fees”
associated with an investment, there is no requirement in SIFMA’s proposal
that the compensation of the broker-dealer or its registered
representative be affirmatively quantified and then disclosed. As a result,
customers will remain uninformed of the precise amount of the compensation of
the broker and its registered representative. Hence, the client will not
possess the means to assess the reasonableness of the compensation so
provided, and the receipt of only “reasonable compensation” is a requirement
for a fiduciary actor.

No.While
annual disclosure occurs of a product’s “fees and all related expenses,”
there is no requirement in FINRA’s proposal that the compensation of
the broker-dealer or its registered representative be affirmatively
quantified and then disclosed. As a result, customers will remain uninformed
of the precise amount of the compensation of the broker and its registered
representative. Hence, the client will not possess the means to assess the
reasonableness of the compensation so provided, and the receipt of only
“reasonable compensation” is a requirement for a fiduciary actor. Why do
broker-dealer firms resist the fiduciary requirement to fully disclosure a
material fact – their compensation – to their customers? Because a large proportion of these customers believe that their
registered representative and brokerage firm is acting gratuitously,[42]
given broker-dealers’ ability to hide compensation from the customers.[43]

Is there a duty upon the
representative to ensure client understanding of material facts,
including material conflicts of interest?

Yes.

No.Under SIFMA’s
proposal disclosures must only be “designed to ensure client
understanding.” There is no requirement, as exists for a fiduciary, that
client understanding of conflicts of interest, and their ramification,
actually occur.

No.Under FINRA’s
proposal disclosures relating to products must only be provided to the
customer. There is no requirement, as exists for a fiduciary, that client
understanding of conflicts of interest, and their ramification, actually
occur by means of affirmative obligations placed upon the registered
representative.

Is informed consent of the client
required prior to the client undertaking each and every recommended
transaction?

Yes.

No. There is no
requirement in SIFMA’s proposal that the client’s consent be “informed” – a
key requirement of fiduciary law before client waiver of a conflict of
interest can take place. Nor is there a requirement that the client provide
informed consent prior to each and every transaction. Rather, SIFMA would
only require: “Customer consent to material conflicts of interest or
for other purposes as appropriate may be provided at account opening.”
Of course, consent “at client opening” often involves a customer briefly
initialing a line, as one of many initials or signatures provided in account
opening forms which are often dozens of pages long. The result of
SIFMA’s proposal is that clients can and will consent to be harmed – an
outcome which cannot exist under a bona fide fiduciary standard. And such
“consent” will hardly ever be “informed.”

No. There is no
requirement in FINRA’s proposal that the client’s consent be “informed” – a
key requirement of fiduciary law before client waiver of a conflict of
interest can take place. Nor is there a requirement that the client provide
informed consent prior to each and every transaction. Rather, FINRA would
only require brokers to “obtain client consent” to conflicts of interest.
Such consent, often given with little or no understanding by the customer of
the broker, creates an estoppel defense for the broker, who is in an
arms-length relationship with the customer. As explained in this comment
letter, the role of estoppel is very limited in fiduciary relationships, and
much more than “simple consent” is required for the fiduciary to proceed when
a conflict of interest is present.

Must the transaction remain, at all
times, substantively fair to the client?

Yes.

No. There is only a
requirement that the transaction be in accord with the client’s “best
interest” – a new SIFMA-proposed standard that is ill defined and which
remains subject to much interpretation. Such interpretations will primarily
occur through FINRA’s much-maligned system of mandatory arbitration. In
contrast, the fiduciary standard possesses centuries of interpretation and
application. Under a bona fide fiduciary standard, clients are unable to
waive core fiduciary duties; the role of estoppel is quite limited. This is
enforced by the courts by requiring both informed consent of the
client and that the transaction remain substantively fair to the
client.

No. There is only a
requirement that the transaction be in accord with the client’s “best
interest” – a new FINRA-proposed standard that is ill defined and which
remains subject to much interpretation. Such interpretations will primarily
occur through FINRA’s much-maligned system of mandatory arbitration. In
contrast, the fiduciary standard possesses centuries of interpretation and
application. Under a bona fide fiduciary standard, clients are unable to
waive core fiduciary duties; the role of estoppel is quite limited. This is
enforced by the courts by requiring both informed consent of the
client and that the transaction remain substantively fair to the
client.

Does there exist a duty to properly
manage investment-related fees and costs that the client will incur at
all times?

Yes.

No. SIFMA expressly
states: “Managing investment-related fees does not require recommending the
least expensive alternative, nor should it interfere with making
recommendations from among an array of services, securities and other investment
products consistent with the customer’s investment profile.” These caveats
leave the door wide open for the broker to recommend highly expensive
products, including products which pay the broker more, in which the total
fees and costs incurred by the customer will substantially lower the
long-term returns of the investor.

No. FINRA does not appear to recognize that, under fiduciary law, there is
an obligation imposed upon the fiduciary to ensure that any expenditures of
the client’s funds, through payment of product-related fees and costs, be
undertaken with close scrutiny. FINRA appears to desire that high-cost
products could still be recommended compared with lower-cost products that
possess nearly the same risk and other characteristics. The fiduciary
standard of due care requires that the client’s expenses be controlled and
that avoidable expenses be avoided. The fiduciary is permitted to obtain
reasonable, professional-level compensation, through agreement with the
client at the inception of the relationship, and with full disclosure of
same.

Does there exist a duty to properly
manage the design, implementation and management of the portfolio, in order
to reduce the tax drag upon the customer’s investment returns?

Yes.

No. There is no
express duty under SIFMA’s proposal to properly manage the tax consequences
of investment decisions. Far too often under the suitability standard, and
under this proposed “best interests” standard, customers of broker-dealers
have and will possess substantial tax drag upon their investment returns that
otherwise could have been avoided through expert advice.

No. Nothing in FINRA’s proposal addresses portfolio management. FINRA is
mired in the ancient practice of providing products under the suitability
standard. Today’s investors deserve expert advice from true fiduciaries, not
the sale of products which generate high profits for the broker without
proper consideration of how the product fits into the client’s overall
portfolio.

As seen, SIFMA’s and FINRA’s proposed “Best Interests”
standards fall far short of the protections afforded by ERISA’s fiduciary
standard. The fact of the matter is that Wall Street wants to eat its cake and
have it too. It wants to be perceived as acting in customer's "best
interests," but enjoy the freedom to act in its own interests. Wall
Street’s new “Best Interests of the Consumer” proposal is, in reality, only
“Wall Street’s Self-Interest.”

As alluded to in the chart above, by its “Best
Interests” proposal SIFMA and FINRA do not turn brokers from sell-side
merchandizers into buy-side purchaser’s representatives and fiduciaries. Rather,
SIFMA’s and FINRA’s proposal are nothing more than an attempt to obfuscate into
some kind of obscene and confusing hybrid between the two. In fact, the
enhancement to the inherently weak suitability standard under these proposals
is extremely modest.

This begs the question – who does the broker under
SIFMA’s and FINRA’s proposed “best interests” standards represent? This is a
key question, for the following is well known in the law:

The
characters of buyer and seller are incompatible, and cannot safely be exercised
by the same person. Emptor emit quam
minimo potest; venditor vendit quam maximo potest. The disqualification
rests … on no other than that principle which dictates that a person cannot be
both judge and party. No man can serve two masters. He that it interested with
the interests of others, cannot be allowed to make the business an object of
interest to himself; for, the frailty of our nature is such, that the power
will too readily beget the inclination to serve our own interests at the expense
of those who have trusted us.[44]

It is obvious that under SIFMA’s and FINRA’s proposed
“best interest” standards the registered representative would continue to act
as sellers of products, thereby representing the broker-dealer firm and product
manufacturers. This is a far, far cry from acting as a fiduciary, and acting as
the representative of the purchaser. And it fails to achieve a key objective
that the U.S. Department of Labor alluded to in its release for the BIC
exemption: “In the absence of fiduciary status, the providers of investment
advice are neither subject to ERISA's fundamental fiduciary standards, nor
accountable for imprudent, disloyal, or tainted advice under ERISA or the Code,
no matter how egregious the misconduct or how substantial the losses.”[45]

The U.S. Department of Labor should reject any proposal
from SIFMA, FINRA, or broker-dealer firms, or insurance companies, which seeks
to advance such a woefully inadequate rule. These are proposals that, like the
suitability standard today, protect Wall Street, and utterly fail to protect
consumers from Wall Street’s greed.

Let us not permit Wall Street profess to act in the "best
interests" of customers, when any sensible consumer would conclude that
Wall Street's definition of "acting in your best interests" is wholly
deceptive to consumers. Such fraud[46] has no
place in government regulatory efforts, nor even in self-regulatory organization
rulemaking activities. SIFMA’s and FINRA’s proposals should be loudly and
firmly rejected by the DOL and other policymakers. And the recent embrace by
FINRA of SIFMA’s proposal should subject FINRA to further scrutiny over whether
FINRA’s market conduct regulation of brokers should be transferred back to federal
and state governments for direct oversight,[47]
especially when FINRA characterizes its proposal as a “fiduciary ‘best
interests’” proposal – when it clearly is not.

Raised within the legacy of Adam
Smith, as a lifelong student of economics and a professor of finance, I am a
committed Capitalist. I believe in our Free Market Economy, its opportunities
presented to all, and the immutable Spirits of Innovation and Entrepreneurship,
and our personal drive to seize and profit from opportunity. America was
founded in part upon these and other principles.

John Locke, whose words so
influenced our founding fathers that their majesty found way into our
Declaration of Independence, espoused the natural rights of man and the right
to retain of each of us to retain his or her income and property.

Locke conceived of the concept of government
wherein citizens give over these rights (some wholly, others only partially) to
government in trust, as a means of protecting the natural rights of man. In
essence, those who we elect to represent us in our republican form of government
are bound by fiduciary principles to use the power so entrusted to balance the
competing needs of those in society, as we would ourselves.

John Locke is well known for the
principle that each of us possess the rights to his or her own property. However,
libertarians quoting John Locke often overlook Locke’s spirit of compassion for
his neighbors, and his belief in the role of charity. In his Second Treatise Concerning Civil Government,
Locke observed this law of reason:

Whatsoever then he removes out of
the state that nature hath provided, and left it in, he hath mixed his labour
with, and joined to it something that is his own, and thereby makes it his
property. It being by him removed from the common state nature hath placed it
in, it hath by this labour something annexed to it, that excludes the common
right of other men: for this labour being the unquestionable property of the
labourer, no man but he can have a right to what that is once joined to, at least where there is enough, and as good,
left in common for others … Charity gives every Man a Title to so much out
of another’s Plenty, as will keep him from extream
want, where he has no means to
subsist otherwise. (Emphasis added.)

Many of us derive the basis of our
own personal political and economic views from philosophers such as John Locke.
Yet Locke and others recognize that opposing rights exist among the members of
a society, and accordingly the rights of men and women must be balanced. As even
John Locke alluded to, the right to generate profits from own labors has
limits. In certain situations duties are imposed through government law and
regulation to protect those susceptible to harm. Hence, government has a role
to play to ensure that the rights of all of its citizens are balanced and
respected.

Armed with the understanding that one
father of libertarianism believes that government has a role to play in the
regulation of the affairs of men, we now turn to the words of another father of
libertarianism, Adam Smith, widely known as also the founder of Modern
Economics. Perhaps all of us are aware of Adam Smith’s The Wealth of Nations, published in 1776, in which he famously and
correctly argued that economic behavior was motivated by self-interest,
writing: “It is not from the benevolence of the butcher, the brewer, or the
baker, that we expect our dinner, but from their regard to their own interest.
We address ourselves, not to their humanity but to their self-love, and never
talk to them of our own necessities but of their advantages.”

As Adam Smith pointed out,
capitalism has its positive effects. Actions based upon self-interest often
lead to positive forces that benefit others or society at large. As capital is
formed into an enterprise, jobs are created. Innovation is spurred forward,
often leading to greater efficiencies in our society and enhancement of
standards of living. Indeed, a person in the pursuit of his own interest
“frequently promotes that of the society more effectually than when he really
intends to promote it.”

Yet, while Smith espoused the principle
of the free market, he also advocated the principle of constraint. While Adam
Smith saw virtue in competition, he also recognized the dangers of the abuse of
economic power in his warnings about combinations of merchants and large
mercantilist corporations. In essence, Adam Smith balanced the “commercial
society” with the judicious hand of a paternalistic state.

Adam Smith also recognized the
necessity of professional standards of conduct, for he suggested qualifications
“by instituting some sort of probation, even in the higher and more difficult
sciences, to be undergone by every person before he was permitted to exercise
any liberal profession, or before he could be received as a candidate for any
honourable office or profit.” In essence, long before many of the professions
became separate, specialized callings, Smith advanced the concepts of high
standards of conduct.

Unfettered capitalism results in
greed. Unconstrained the excesses of capitalism become apparent, as evidenced
by the misconduct which fostered financial crisis of 2008-8, the resulting
Great Recession, and untold suffering imposed upon millions of our fellow
Americans. The fiduciary standard, at its core, is a restraint upon greed.

Into the void of wholly free markets,
efficient government regulation is altogether necessary. For, to quote the
words of one of America’s founding fathers, James Madison, “If men were angels,
no government would be necessary.”

Many believe in small, efficient
government. But even the fathers of libertarisim, John Locke and Adam Smith,
recognized the need for certain constraints to be imposed by government upon
the conduct of men and women, lest greed run amuck and destroy our great
country.

In every commercial relationship
misrepresentations in contract formation are outlawed and good faith in
performance is required. In certain situations the purchaser is aided by
disclosures of certain facts, mandated by law and regulation, as a means to
evaluate whether to enter into the transaction. Even with mandated additional
disclosures, however, the relationship between the parties is arms-length, and
the consumer possesses the duty of personal due diligence under the doctrine of
caveat emptor – “let the buyer
beware.”

Yet, in some forms of relationships
much more is required than just the mere avoidance of actual fraud, performance
of one’s contractual obligations in good faith, and even the making of required
disclosures. In these types of relationships fiduciary obligations are imposed
upon the provider of goods and services. These fiduciary duties include the
fiduciary duty of loyalty, which requires the fiduciary to step into the shoes
of the entrustor (client) and act in the client’s sole interests or best
interests. The fiduciary duties also encompass due care, which requires the
fiduciary to possess and exercise a high level of expertise.

The result of the imposition of
fiduciary duties is a complete change in the role of the provider of goods or
services. No longer does the advisor act as a merchandizer – representing the
manufacturer or dealer of a product. Rather, the advisor is transformed, wholly
and absolutely, into a representative of the purchaser of the good or service.

Why does such a dramatic
transformation in the form of the commercial relationship mandated in these
instances? It is because trust is not an absolute, in that it either exists or
does not exist. Rather, trust falls along a continuum. In many commercial
relationships the purchaser is aware of the need to exercise his or her own due
diligence prior to entering into, or consummating, the transaction; in such
instances the need for trust is minimal. But, in this increased era of
specialization in society, and vast disparities in knowledge and expertise when
dealing with complex matters, a much higher degree of trust must be present in
order to protect consumers who receive certain types of services, such as investment
advice.

During the provision of specialized goods
and services (including advice) that society treasures and where a vast
imbalance of knowledge and expertise is present, the purchaser of goods or
services is at such a disadvantage the purchaser’s own due diligence cannot
guard against the potential for abuse by the service provider. In these
situations the law rightly and justly goes further and imposes fiduciary status upon the provider of
such goods or services.

The consumer of investment products
and services today is simply overwhelmed by information. Our fellow Americans
are thrust into a highly complex financial environment in which a high degree
of expertise is required to properly undertake portfolio design and management,
and investment product selection. To prosper in today’s modern financial world
requires not just the ability to understand often-complex financial products,
but also a knowledge of Modern Portfolio Theory (MPT), concepts intertwined
with MPT (such as variance, correlation, and the benefits of diversification),
strategic vs. tactical asset allocation, multi-factor models of risks and
returns, tax and risk characteristics of various asset classes and particular
investments, the extent of regulation (or non-regulation) of various types of
investment managers, and much, much more.

Where such information disparity and
complexity exists, “the traditional tools for supervising counterparties,
available through the law of contract, cannot guarantee the effective delivery
of specialized services. Individuals simply do not have the resources or the
expertise to determine on their own whether these specialized services are
actually serving their interests. Instead, these individuals need to trust that the specialists they rely
upon will keep their best interests at heart.”[48]

Accordingly, by necessity our consumers
justly rely upon specialists. Just as they do in medicine, law, and other
disciplines, consumers rely on financial and investment advisers to help them
take advantage of the many advances in understanding of how the capital markets
function and how the returns of the capital markets can be brought to bear to achieve
the individual’s lifetime financial goals.

As
Professor Tamar Frankel, long the leading scholar in the area of fiduciary law
as applied to securities regulation, once observed:

[A] prosperous economy develops specialization.
Specialization requires interdependence. And interdependence cannot exist
without a measure of trusting. In an entirely non-trusting relationship
interaction would be too expensive and too risky to maintain. Studies have
shown a correlation between the level of trusting relationships on which
members of a society operate and the level of that society’s trade and economic
prosperity.[49]

Fiduciary
duties are imposed by law when public policy encourages specialization in
particular services, such as investment management or law, in recognition of
the value such services provide to our society.For example, the provision of investment consulting services under
fiduciary duties of loyalty and due care encourages participation by investors
in our capital markets system. Hence, in order to promote public policy goals,
the law requires the imposition of fiduciary status upon the party in the
dominant position. Through the imposition of such fiduciary status the client
is thereby afforded various protections. These protections serve to reduce the
risks to the client that relate to the service, and encourage the client to
utilize the service. Accordingly, the imposition of fiduciary status thereby
furthers the public interest.

Some might opine that financial
literacy efforts can fulfill this role. Yet, the body of academic research, and
my own experience in dealing with thousands of clients, reveals that financial
literacy efforts only significantly assist consumers with basic personal
finance training, such as in expenditures budgeting and saving for future
needs. However, the complexity of the financial markets, and the limits of time
each consumer possesses to devote to training in finance, renders the vast
majority of consumers unable to become investment experts or to understand the
many terms and concepts required, even with the aid of a multitude of
disclosures. We are just as likely to turn a consumer of financial services
into a highly knowledgeable designer and manager of her or his investment
portfolio as we are to turn a patient needing a brain operation into a
neurosurgeon.

We must recognize that the
combination of specialization and interdependence found today is essential to the
progress of our society. This combination fosters both the development of new
knowledge and expertise. It provides great benefits to consumers, provided the
advice is delivered with a high degree of due care and in the consumers’ best
interests. It enables consumers to place the fruits of their hard-earned labor to
work in the capital markets, with the expectation that the returns offered by
the markets will be returned to the consumer, less only a reasonable amount for
professional-level compensation to the specialist and the carefully scrutinized
fees and costs of any investment product.

In this section, we must first ask,
“What is ‘trust’?” I submit that there exists “at least implicitly accepted a
definition of trust as a belief, attitude, or expectation concerning the
likelihood that the actions or outcomes of another individual, group or
organization will be acceptable . . . or will serve the actor’s interests.”[50]

How important is trust to commerce,
generally? Aristotle once observed that the doctrine of good faith is so
fundamental to the making and performance of contracts that, “[i]f good faith
has been taken away, all intercourse among men ceases to exist.”

Trust itself is also crucial to a
society’s economic success. Nobel laureate economist Kenneth Arrow has stated
that “[v]irtually every commercial transaction has within itself an element of
trust,” and that “much of the economic backwardness in the world can be
explained by the lack of mutual confidence.”[51]

Several studies have documented the
positive relationship between trust in society and economic growth. Increased
trust between actors in commercial transactions has a direct positive and
significant effect on income per capita growth.[52]

Individuals need to trust that the
specialists they rely upon will keep their best interests at heart. The
imposition of broad fiduciary duties of due care, loyalty, and utmost good
faith promotes this essential relationship of trust. It permits entry into the
capital markets by those without the knowledge and skill to navigate their
complex waters. As stated by Luhmann:

Trust
is necessary in order to face the unknown, whether that unknown is another
human being, or simply the future and its contingent events. Seldom, if ever,
can we obtain all the information we would need in order to take decisions in a
completely rational manner. At a certain point in our 'intelligence-gathering'
about the world we have to call a halt, say ‘enough is enough’ and take a
decision based on what we know and the way we feel. That decision will
inevitably partly be based on trust. Trust is thus a way of reducing
uncertainty. It lies somewhere between hope and confidence, and involves an
element of semi-calculated risk-taking. Trust, by the reduction of complexity,
discloses possibilities for action which would have remained unattractive and
improbable without trust - which would not, in other words, have been pursued.[53]

I have personally seen the trust of
consumers betrayed, over and over again, by providers of financial and
investment advice who act out of their own self-interest, not bound by a
fiduciary standard. Immense personal harm results, involving the destruction of
the hopes and dreams of the consumer.

For society the cost of abuse of
trust in the provision of investment advice is even greater. I have personally seen
consumers, burned and unwilling to trust any other financial or investment
adviser, flee from the capital markets – likely for all time. Like most of the
Greeks, such consumers resort to placement of their savings in commercial
banks. As a result, the costs of capital increase, for the capital markets are
deprived of direct funding and the provision of available equity capital, in
particular, is diminished.

Investment
advisory services rendered in a relationship of trust and confidence, as a
fiduciary, encourage participation by investors in our capital markets system,
which in turn promotes economic growth. The first and overriding responsibility
any financial professional has is to all of the participants of the market.
This primary obligation is required in order to maintain the perception[54] and reality that the
market is a fair game and thus encourage the widest possible participation in
the capital allocation process. The premise of the U.S. capital market is that
the widest possible participation in the market will result in the most
efficient allocation of financial resources and, therefore, will lead to the
best operation of the U.S. and worldwide economy. Indeed, academic research has
revealed that individual investors who are unable to trust their financial advisors
are less likely to participate in the capital markets.[55]

C. Other Compelling
Reasons for Imposition of Fiduciary Status

The key
to understanding fiduciary principles, and why and how they are applied, rests
in discerning the foregoing public policy objectives the fiduciary standard of
conduct is designed to meet, as well as the other public policy objectives set
forth in this section.

The
Investment Advisers Act of 1940 “recognizes that, with respect to a certain
class of investment advisers, a type of personalized relationship may exist
with their clients … The essential purpose of [the Advisers Act] is to protect
the public from the frauds and misrepresentations of unscrupulous tipsters and
touts and to safeguard the honest investment adviser against the stigma of the
activities of these individuals by making fraudulent practices by investment
advisers unlawful.”[56] “The Act was designed to
apply to those persons engaged in the investment-advisory profession -- those
who provide personalized advice attuned to a client's concerns, whether by
written or verbal communication[57] … The dangers of fraud,
deception, or overreaching that motivated the enactment of the statute are present
in personalized communications….”[58]

The
inability of clients to protect themselves while receiving guidance from a
fiduciary does not arise solely due to a significant knowledge gap or due to
the inability to expend funds for monitoring of the fiduciary. Even highly
knowledgeable and sophisticated clients (including many financial institutions)
rely upon fiduciaries. While they may possess the financial resources to engage
in stringent monitoring, and may even possess the requisite knowledge and skill
to undertake monitoring themselves, the expenditure of time and money to
undertake monitoring would deprive the investors of time to engage in other
activities. Indeed, since sophisticated and wealthy investors have the ability
to protect themselves, one might argue they might as well manage their
investments themselves and save the fees. Yet, reliance upon fiduciaries is
undertaken by wealthy and highly knowledgeable investors and without expenditures
of time and money for monitoring of the fiduciary. In this manner, “fiduciary
duties are linked to a social structure that values specialization of talents
and functions.”[59]

In service provider relationships
which arise to the level of fiduciary relations, it is highly costly for the
client to monitor, verify and ensure that the fiduciary will abide by the
fiduciary’s promise and deal with the entrusted power only for the benefit of
the client. Indeed, if a client could easily protect himself or herself from an
abuse of the fiduciary advisor’s power, authority, or delegation of trust, then
there would be no need for imposition of fiduciary duties. Hence, fiduciary
status is imposed as a means of aiding consumers in navigating the complex
financial world, by enabling trust to be placed in the advisor by the client.

Fiduciary
relationships are relationships in which the fiduciary provides to the client a
service that public policy encourages. When such services are provided, the law
recognizes that the client does not possess the ability, except at great cost,
to monitor the exercise of the fiduciary’s powers. Usually the client cannot
afford the expense of engaging separate counsel or experts to monitor the
conflicts of interest the person in the superior position will possess, as such
costs might outweigh the benefits the client receives from the relationship
with the fiduciary. Enforcement of the protections thereby afforded to the
client by the presence of fiduciary duties is shifted to the courts and/or to
regulatory bodies. Accordingly, a significant portion of the cost of
enforcement of fiduciary duties is shifted from individual clients to the
taxpayers, although licensing and related fees, as well as fines, may shift
monitoring costs back to all of the fiduciaries that are regulated.

The
results of the services provided by a fiduciary advisor are not always related
to the honesty of the fiduciary or the quality of the services. For example, an
investment adviser may be both honest and diligent, but the value of the
client’s portfolio may fall as the result of market events. Indeed, rare is the
instance in which an investment adviser provides substantial positive returns
for each incremental period over long periods of time – and in such instances
the honesty of the investment adviser should be suspect.

Most
individual consumers of financial services in America today are unable to
identify and understand the many conflicts of interest that can exist in
financial services. For example, a customer of a broker-dealer firm might be
aware of the existence of a commission for the sale of a mutual fund, but
possess no understanding that there are many mutual funds available that are
available without commissions (i.e., sales loads). Moreover, brokerage firms
have evolved into successful disguisers of conflicts of interest arising from
third-party payments, including payments through such mechanisms as contingent
deferred sales charges, 12b-1 fees, payment for order flow, payment for shelf
space, and soft dollar compensation.

Survey
after survey (including the Rand Report) has concluded that consumers place a
very high degree of trust and confidence in their investment adviser,
stockbroker, or financial planner. These consumers deal with their advisors on
unequal terms, and often are unable to identify the conflicts of interest their
“financial consultants” possess.

Transparency
is important, but even when compensation is fully disclosed, few individual
investors realize the impact high fees and costs can possess on their long-term
investment returns; often individual investors believe that a more expensive
product will possess higher returns.[60] Nor will competition,
even with transparency, serve to substantially lower costs due to the economic
incentives advisers possess to sell higher-cost funds.[61]

How
does one prove oneself to be “honest” and “loyal”?The cost to a fiduciary in proving that the
advisor is trustworthy could be extremely high – so high as to exceed the
compensation gained from the relationships with the advisors’ clients.

Investment advisers’
professionalism, and particularly their professional ethics, dominated the SEC
study and the legislative history of the Act. Industry spokespersons emphasized
their professionalism. The “function of the profession of investment counsel,”
they said, “was to render to clients on a personal basis competent, unbiased
and continuous advice regarding the sound management of their
investments.”In terms of their
professionalism they compared themselves to physicians and lawyers. However,
industry spokespersons indicated that their efforts to maintain professional
standards had encountered a serious problem.The industry, they said, covered “the entire range from the fellow
without competence and without conscience at one end of the scale, to the
capable, well-trained, utterly unbiased man or firm, trying to render a purely
professional service, at the other end.” Recognizing this range, “a group of
people in the forefront of the profession realized that if professional standards
were to be maintained, there must be some kind of public formulation of a standard
or a code of ethics.” As a result, the Investment Counsel Association of
America was organized and issued a Code of Ethics. Nonetheless, the problem
remained that the Association could not police the conduct of those who were
not members nor did it have any punitive power.

As a result of the Commission’s
report to Congress, the Senate Committee on Banking and Currency determined
that a solution to the problems of investment advisory services could not be
affected without federal legislation. In addition, both the Senate and House
Committees considering the legislation determined that it was needed not only
to protect the public, but also to protect bona fide investment counselors from
the stigma attached to the activities of unscrupulous tipsters and touts. During
the debate in Congress, the special professional relationship between advisers
and their clients was recognized. It is, said one representative, “somewhat
[like that] of a physician to his patient.” The same Congressman continued that
members of the profession were “to be complimented for their desire to improve
the status of their profession and to improve its quality.”[62]

This is
why it is important to fiduciary advisors to be able to distinguish themselves
from non-fiduciaries. A recent example of the problems faced by investment
advisers was the “fee-based brokerage accounts” final rule adopted by the SEC
in 2005, which would have permitted brokers to provide the same functional
investment advisory services as investment advisers but without application of
fiduciary standards of conduct. This would have negated to a large degree
economic incentives[63] for persons to become
investment advisers and be subject to the higher standard of conduct.The SEC’s fee-based accounts rule was
overturned in Financial Planning Ass'n v.
S.E.C., 482 F.3d 481 (D.C. Cir., 2007).

The
ability of “the market” to monitor and enforce a fiduciary’s obligations, such
as through the compulsion to preserve a firm’s reputation, is often ineffective
in fiduciary relationships. This is because revelations about abuses of trust
by fiduciaries can be well hidden (such as through mandatory arbitration
clauses and secrecy agreements regarding settlements), or because marketing
efforts by fiduciary firms are so strong and pervasive that they overwhelm the
reported instances of breaches of fiduciary duties.

I fully support the DOL’s expanded
definition of “fiduciary.” This definition is better in accord with the actual
language of the statute. Additionally, the expanded definition encompasses most
of the relationships of trust and confidence, for the provision of investment
advice to retirement accounts, to which fiduciary status usually attaches under
state common law, which common law serves to inform the development of federal
law.

SIFMA, FSI and other broker-dealer
lobbyists, and insurance company lobbyists, have proclaimed loud and clear that
small investors cannot be served under the DOL’s best interest proposal. The
fallacy of this argument is evident in the fact that, for decades, fiduciary
advisers have been serving both plan sponsors and individual clients, of all
sizes, under a bona fide fiduciary standard of conduct, and doing so extremely
well and with the clients paying far less in fees and costs than the
compensation paid to registered representatives and to insurance agents.

Fiduciary
Advice is Readily Available to Even Small Investors

For example, suppose an investor
desires to invest $10,000 in an IRA account. Currently many such investors
succumb to the marketing prowess of Wall Street and end up undergoing a brief
conversation with a broker (i.e., a registered representative) and thereafter
receive a singular investment recommendation.

Often that broker’s recommendation
is to invest IRA account cash into a Class A mutual fund shares, in which the
broker charges a 5.75% upfront commission. In addition to the $575 up-front
commission on a $10,000 account, ongoing 12(b)-1 fees are also typically paid
to the brokerage firm, usually in the amount of 0.25% a year. These commissions
and annual fees are in addition to the management and administrative fees
charged by the fund itself.

And, far too often, a portion of the
often-high mutual fund management fees is paid to the brokerage firm as
“payment for shelf space” or via sponsorship of events at “educational
gatherings” at brokerage firms.

Wall Street’s large firms have often
made threats to abandon smaller investors as regulators contemplate changes to
rules governing their conduct. What if they make good on those threats? Should
fiduciary obligations be imposed upon brokers who provide personalized
investment advice? The Financial Services Institute complains loudly about the
U.S. Department of Labor’s proposed Conflicts of Interest Rule and its
broadened imposition of fiduciary standards of conduct that “millions of
hard-working Americans could find financial advice priced out of their reach.”

The other major broker-dealer
lobbyist organization, SIFMA, argues that adoption of fiduciary standards of
conduct for those who provide personalized investment advice to consumers “is
likely to have a negative impact on consumers, particularly smaller investors.”

Does
Wall Street serve the small investor?

Before I proceed to rebut these
fallacious arguments, I must point out that many of the larger broker-dealer
firms mandate minimums for their registered representatives to receive
compensation, which discourages such brokers from providing services to small
investors. Often, individual brokers are not compensated until the account size
grows to $100,000 or even $500,000.

As a result, these smaller investors
are often directed to advisors located in “call centers,” if they are served at
all. Hence, to the extent Wall Street firms threaten to “abandon” small
investors, it must first be realized that many of these brokerage firms have,
in essence, already largely abandoned smaller investors.

Still, we must ask: do FSI’s and
SIFMA’s claims hold merit? Will small investors not be served if brokers
abandon the small IRA account-owner market? More specifically, we might
inquire: “Where else can a small IRA investor receive investment advice on a
$10,000 IRA account, for $575 or less?”

Let’s examine the evidence, by
looking at just a few of the offerings that currently exist to serve small IRA
investors.

Garrett
Planning Network: Fiduciary, hourly advice

One group has long existed to
provide advice to investors both large and small. Its vision is succinctly
explained on their website: “Everyone needs competent, objective financial
advice from time to time. The Garrett Planning Network has a nationwide
membership of over 300 independent, fee-only financial planners providing
advice to people from all walks of life, without minimum account requirements,
sales commissions, or long-term commitments. Our members proudly embrace their
fiduciary duty, always placing their clients’ best interests first.”

When Sheryl Garrett founded the
Garrett Planning Network (currently celebrating its 15th year), its
groundbreaking philosophy was to provide fee-only, fiduciary advice under
hourly fee arrangements. Since then, Sheryl’s vision has substantially
influenced the industry. Innovations have been adopted by many of its members
in recent years, such as the “two-hour financial checkup” — often costing only
about $300 to $500.

Not only might the consumer receive
a recommended strategic asset allocation, as well as specific investment
recommendations, but these recommendations are provided in context with
financial planning recommendations around the key issues the client may face at
that moment. Given the high quality of the truly objective financial and
investment advice provided, the consumer gets far greater and better advice for
fees that are lower. And, since all GPN’s advisors eschew third-party payments
such as 12(b)-1 fees, and nearly all favor very-low-cost, no-load mutual funds,
clients incur far less total fees and costs over the long run.

In a recent e-mail exchange I had with
Sheryl Garrett, she opined: “Demand for investment advisory services from our
members is great and increasing exponentially. The marketplace has changed
significantly, driven in part by public awareness of the benefits of working
with a fiduciary advisor. Advisors also are attracted to the fiduciary space,
as it puts them on the same side of the table as their clients. If brokerage
firms stop serving small investors just because they will now be forced to do
what is in a client’s best interest, there are a lot of fiduciary advisors who
are willing to take up the slack and take care of these investors’ advisory
needs.”

No wonder President Obama chose to
highlight Sheryl Garrett in her visit to the White House earlier this year, as
he announced his support of the DOL’s rulemaking efforts.

NAPFA:
The largest network of fee-only advisors

More than 30 years ago a group of
industry visionaries gathered and established a professional organization that
has now grown to over 2,400 members, with members located in 49 of the 50
states. The nation’s largest professional organization of fee-only personal
financial advisors, the National Association of Personal Financial Advisors —
NAPFA — has members ranging from solo practitioners to some of the largest
registered investment advisory firms in the United States today, many of them
serving thousands of individual investors.

While some NAPFA member firms have
minimums, many others do not — even many of the larger NAPFA-member firms. For
example, Abacus Wealth Partners, a fee-only firm with over $1 billion of assets
under management, has six offices and serves clients in 40 different states.
Abacus offers consumers a “Financial Checkup” involving a two-hour phone or
in-person session with a 30-minute telephone follow-up. For a fixed fee of
$600, small IRA investors and other clients can receive financial and
investment advice.

“We’ve made it part of our mission
to serve anyone who needs our help,” J.D. Bruce, president of Abacus Wealth
Partners, conveyed to me via a recent e-mail. “We’ve eliminated our investment
management minimum and we find a way to offer some level of financial planning,
even if we have to do it for free through our pro-bono program. It’s not that
we’re a charity, we still make a good profit, and our high net-worth prospects
appreciate our mission and are more likely to hire us and refer us their
friends.”

XY
Planning Network: Monthly retainer, no asset minimums

A relatively newer but rapidly
growing organization of fee-only, fiduciary advisors is the XY Planning
Network. All of its advisors offer monthly retainer services and none of them
require asset minimums. Many of the XY Planning Network’s members also offer
consultations for hourly fees or fixed fees.

A typical example of XY Planning
Network’s members is Ben Wacek, a fee-only, Certified Financial Planner who
provides financial and investment advice online and through phone calls. In
addition to a 30-minute free phone call “to get to know each other and see if I
can help,” Ben provides hourly financial advice for only $80 an hour. He also
offers ongoing financial and investment advice through a monthly retainer that
starts at only $50 per month. With seven years experience, Ben says that he
“loves working as a financial planner because of the opportunity that he has to
make a difference in people’s lives.”

Robo-advisors:
Badly named but there for the little guy

Several recently formed firms offer
investment advisory services through a combination of automated services and/or
human interactions. They build and manage low-cost portfolios at a fraction of
what investors typically pay human advisors. These firms, incorrectly but
commonly called “robo-advisors,” apply technology to bring efficiencies to the
investment advisory process. Given that the Internet and technology in general
has led to wholesale disintermediation in many different industries, it is no
surprise that such firms have arisen in the online investment advisory space.

One of the largest of these new
offerings is from nonprofit, low-cost mutual fund provider The Vanguard Group.
However, its Vanguard Personal Advisor Services currently has a $50,000 minimum.
Under this platform Vanguard now manages billions and billions of assets for
individual investors.

Perhaps more representative of the
new type of fee-only, fiduciary online advisory services is investment advisory
online firm Wealthfront Inc. Wealthfront does not charge an advisory fee on the
first $10,000 of assets under management. On amounts over $10,000, Wealthfront
charges a monthly advisory fee based on an annual fee rate of 0.25%. Hence, the
annual investment advisory fee on a $10,000 account is only $250. The only
other direct cost clients incur is the very low fee embedded in the annual
expense ratio of the exchange traded funds it recommends; Wealthfront states
that these fees average only 0.12% a year. With over $2.4 billion in assets
under management in just a relatively short period of time, Wealthfront stands
ready to provide investment solutions to hundreds of thousands, if not
millions, of potential small IRA customers. Other online investment advisory
firms exist, with several more currently in the process of forming.

What
do the Wall Street threats really mean?

Wall Street’s large firms have often
made threats to abandon smaller investors as regulators contemplate changes to
rules governing their conduct. For example, in 2005-2007, during the Financial
Planning Association’s successful litigation in overturning the SEC’s ill-fated
“fee-based accounts rule,” several firms stated that they would be unable to
serve investors if they were forced to switch the fee-based brokerage accounts
to investment advisory accounts. Of course, this was largely an empty threat,
as the end of fee-based brokerage accounts saw many, if not most, of these
fee-based brokerage accounts transformed into investment advisory accounts
governed by the Advisers Act’s fiduciary standard.

If the Department of Labor’s rules
are finalized, then changes to the delivery of investment advice will occur for
some IRA account owners. But these changes will be a great positive, as small
IRA investors would then be provided investment advice by fiduciary advisors
who possess a legal obligation to both control and account for investment fees
and costs. In most instances, not only will the advice received by these small
investors be lower-cost, but the advice will also be better, far more
objective, and much more comprehensive.

This begs the question: Why do the
members of SIFMA and FSI threaten to not serve small IRA account owners under
the DOL’s fiduciary standard?

One might conclude a more logical
explanation exists. Simply put, without the free rein provided by FINRA’s
scandalously weak “suitability standard” to recommend high-cost, expensive
investment products that pay broker-dealer firms and their registered
representatives inordinately high fees (including many pay-to-play and similar
back-door payments), what Wall Street really means is that it cannot afford to
still serve such investors under its current business model if it cannot
continue to reap inordinately high rents from unsuspecting consumers.

Time
to stop feeding the beast

To Wall Street’s empty threats I
would reply as follows. Small IRA investors deserve trusted advice, from expert
investment advisors, for reasonable fees. They don’t deserve to be sold costly
investment products that a huge body of academic research has concluded
deprives individual investors of a significant portion of the returns the
capital markets have to offer.

Nor do the regulators need to permit
this abuse by Wall Street firms of individual investors to continue. Part of
the duty of both the DOL and the SEC is to protect capital formation, which is
highly dependent upon the trust placed in financial intermediaries by
individual investors. The DOL and SEC also serve to protect investors, both
large and small. Nothing in their charters requires either to preserve an
archaic, abusive business model of Wall Street in which perhaps a hundred
billion dollars (or more) are diverted each year from individual investors as a
means to fuel Wall Street firm’s extraordinary levels of compensation, bonuses,
and profits.

The simple truth is that Wall
Street’s sell-side, high-expense model is not desired by knowledgeable small
IRA investors. More importantly, a vast array of better alternatives exist to
serve the small IRA investors. If Wall Street actually were to carry out its
threat to abandon small IRA investors should the DOL finalize its proposed
rules which largely prohibit most of the conflicts of interest Wall Street
firms currently embrace, I say let these firms so depart the marketplace! There
are many, many investment advisory firms willing to provide trusted advice for
reasonable fees to these small IRA investors without the huge conflicts of
interest that cause so much harm to investors.

As to Wall Street’s conflict-ridden,
enormously expensive (for consumers) business model in which excessive rents
are extracted, what should occur? Wall Street’s broker-dealer firms are
dinosaurs, like the genetically modified monster in the recent Jurassic World movie. And, unwilling to
adapt their standards of conduct for the benefit of our fellow Americans and
America itself, Wall Street’s firms dinosaurs that well deserves their own mass
extinction event.

Let us embrace the U.S. Department
of Labor’s proposal to eliminate most of Wall Street’s perverse conflicts of
interest, as these rules when implemented will usher in a new era in which both
small IRA and large IRA investors are able to save and accumulate far greater
amounts for their own personal financial security.

“All other things being equal, the
smaller a fund’s expense ratio, the better the results obtained by its
stockholders … But the burden of proof may reasonably be placed on those who
argue the traditional view –that the search for securities whose prices diverge
from their intrinsic values is worth the expense required.” - Sharpe, William
F. 1966. “Mutual Fund Performance.” Journal of Business, vol. 39, no. 1
(January):119–138.

I am most appreciative of the U.S.
Department of Labor’s efforts to provide an exemption for brokers and insurance
agents to permit the sale of products using commission-based compensation and
other product-provided compensation. This represents a noble effort to
accommodate a large (but ever-declining) segment of the industry that provides
investment advice to plan sponsors and to individual clients.

However, I believe the current BIC
exemption could be misconstrued, in several respects, so as to permit over time
institutionalization of perverse economic incentives and conflicts of interest
that continue to apply to many financial services providers today and which
cause so much harm to individual investors. Hence, below I undertake
recommendations for modifications to the BIC exemption that will strengthen the
requirements of the exemption in order to better protect consumers.

It must be remembered that ERISA
mandates a “sole interests” fiduciary standard of conduct, which is further
augmented by prohibited transaction rules. The DOL possesses the authority to
provide exemptive relief, provided it is the interests of consumers. The BIC
exemption must be carefully constructed to ensure that the interests of
individual investors are protected, and that it is not interpreted incorrectly.

The BIC exemption permits a wide
variety of compensation methods, including but not limited to commissions,
12b-1 fees, payment for shelf space arrangements, and other forms of revenue
sharing, at the brokerage firm level and/or insurance agency level. It is not
necessarily the fact of how these payments are made, but the fact that such
payments may be different depending upon the investment product (or insurance
product) recommended, that creates the first significant hurdle for firms bound
by the fiduciary standard of conduct, and the agents of those firms.

Why
Level Compensation, for Both the Adviser and the Firm, is So Important to
Adhering to a Fiduciary Standard.

Fixed compensation, agreed-to in
advance with the client, is much preferred in fiduciary-client arrangements. As
Professor Laby explained: “It can be difficult ex post to determine the wisdom of an investment recommendation at
the time it was made. A decision to recommend one investment over another is
based on many factors; one can seldom know if self-interest was a motivating
force. The imposition of the fiduciary duty of loyalty and the regulation of
conflicts are ways to control the risk that an investment recommendation will
not be objective.”[64]

As Professor Laby observed above, it
must be recognized that it can take many years of investment manager
performance to be able to test for a fund manager’s skill. As recently observed
by David Blake:

Our
final conclusion is that, while ‘star’ fund managers do exist, all the
empirical evidence – including that presented here – indicates that they are
incredibly hard to identify. Furthermore, it takes a very long time to do so:
Blake and Timmermann (2002) showed that it takes 8 years of performance data
for a test of a fund manager’s skill to have 50% power and 22 years of data for
the test to have 90% power. For most investors, our results show that it is
simply not worth paying the vast majority of fund managers to actively manage
their assets.[65]

The principle that Professor Arthur Laby
summarized above has long been observed by the courts of our country. As
Hallgring explained nearly a half-century ago:

The
courts have consistently held that this inflexibility is essential to its
effective operation … First, the courts have acknowledged that it is difficult,
if not impossible for a person to act impartially in a matter in which he has
an interest…Secondly, the courts have realized that fiduciary relationships
lend themselves to exploitation … Finally, the courts have made much of the
fact that disloyal conduct is hard to detect.[66]

As Fred Reish and Joseph Faucher
more recently expounded:

Conflicts
of interest adversely affect the integrity of the private retirement system. At
the least, the appearance of impropriety calls into question fiduciaries’
loyalty to participants. At worst, a conflict of interest can have a direct
adverse impact on the plan and its participants. For instance, a conflict of
interest, gone unchecked, can result in the plan paying more than reasonable compensation
to service providers or result in fiduciaries offering mediocre and overly
expensive investment options when superior products are available at equal or
less expense. Conflicts of interest, therefore, can adversely affect the
benefits available to participants at retirement – the exclusive purpose for
which retirement plans exist.[67]

The BIC
exemption (and the Principal Transaction Exemption) addresses the problems
posed by differential compensation by requiring that both financial institution
and adviser affirmatively agree to provide investment advice that is in the
best interest of the retirement investor “without regard to the financial or
other interests” of the financial institution, adviser, or other party.” While
the intent of this language appears clear on its face, FINRA in its July 17,
2015 comment letter to the DOL on the proposals suggests three possible
interpretations. FINRA’s third (and correct) interpretation is that under the
BIC exemption “investment advice may be deemed in the customer’s best interest
as long as, among other matters, the amount of compensation earned was not a
factor in the recommendation.” Yet, in the sentence thereafter, FINRA states: “It
is unclear how a financial institution or adviser would demonstrate that the amount
of compensation was not a factor in the recommendation.”

The
clarity FINRA seeks is provided by the DOL itself, in its issuing release for
the BIC exemption:

[B]oth
ERISA section 404(a)(1)(A) and the trust-law duty of loyalty require
fiduciaries to put the interests of trust beneficiaries first, without regard
to the fiduciaries' own self-interest. Accordingly, the Department would expect
the standard to be interpreted in light of forty years of judicial experience
with ERISA's fiduciary standards and hundreds more with the duties imposed on
trustees under the common law of trusts …

Example
3:Fee offset. The Financial Institution
establishes a fee schedule for its services. It accepts transaction-based
payments directly from the plan, participant or beneficiary account, or
IRA,and/or from third party investment
providers. To the extent the payments from third party investment providers
exceed the established fee for a particular service, such amounts are
rebatedto the plan, participant or
beneficiary account, or IRA. To the extent third party payments do not satisfy
the established fee, theplan,
participant or beneficiary account, or IRA is charged directlyfor the remaining amount due.

Other
examples are provided by the U.S. Department of Labor. However, the “fee
offset” example appears to provide the best mechanism for brokers and insurance
companies to ensure adherence that the amount of compensation was not a factor
in the recommendation. I hope this reminder serves to provide FINRA, which seems
completely unable to understand what a true fiduciary standard requires
(despite its acknowledgement, in the early 1940’s, that brokers forming
relationships of trust and confidence with their clients would possess such
fiduciary duties), with the clarity FINRA seeks.

The impact of additional
differential compensation on the individual investor should not be
underestimated. The compensation arrangements permitted under the BIC
exemption, paid by product providers, include commissions (front-end sales
loads), deferred contingent sales charges (DCSC), 12b-1 fees (approximately 80%
of which are paid by mutual funds to brokers), payment for shelf space
(typically paid by a fund’s investment adviser, out of a portion of the
management fees charged to the fund, resulting in economic incentives to keep
management fees high), brokerage commissions paid by funds to brokers (including
the insidious payment of higher commissions as “soft dollar” compensation), and
other forms of revenue-sharing arrangements.

These forms of compensation result
in higher-cost investment products (as additional compensation paid by product
providers to brokers and insurance agents must be recouped through higher-cost
products). Yet, the academic research is compelling in support of the
proposition that investment products with higher fees and costs result, in
average, in lower returns for investors, especially over the long term.

1)
The Market as a” Zero-Sum Game.”

William
F. Sharpe, in his Nobel laureate-winning paper, "The Arithmetic of Active
Management," posited that the stock market was a “zero-sum game.”
Following is an extended excerpt form this important paper:

If
"active" and "passive" management styles are defined in
sensible ways, it must be the case that

(1)
before costs, the return on the average actively managed dollar will equal the
return on the average passively managed dollar and

(2)
after costs, the return on the average actively managed dollar will be less
than the return on the average passively managed dollar

These
assertions will hold for any time period. Moreover, they depend only on the
laws of addition, subtraction, multiplication and division. Nothing else is
required.

Of
course, certain definitions of the key terms are necessary. First a market must be selected -- the stocks in
the S&P 500, for example, or a set of "small" stocks. Then each
investor who holds securities from the market must be classified as either
active or passive.

A
passive investor always holds every security from the market, with each
represented in the same manner as in the market. Thus if security X represents
3 per cent of the value of the securities in the market, a passive investor's
portfolio will have 3 per cent of its value invested in X. Equivalently, a
passive manager will hold the same percentage of the total outstanding amount
of each security in the market.

An
active investor is one who is not passive. His or her portfolio will differ
from that of the passive managers at some or all times. Because active managers
usually act on perceptions of mispricing, and because such misperceptions
change relatively frequently, such managers tend to trade fairly frequently --
hence the term "active."

Over
any specified time period, the market
return will be a weighted average of the returns on the securities within
the market, using beginning market values as weights3. Each passive manager
will obtain precisely the market return, before costs4. From this, it follows
(as the night from the day) that the return on the average actively managed
dollar must equal the market return. Why? Because the market return must equal
a weighted average of the returns on the passive and active segments of the
market. If the first two returns are the same, the third must be also.

This
proves assertion number 1. Note that only simple principles of arithmetic were
used in the process. To be sure, we have seriously belabored the obvious, but
the ubiquity of statements such as those quoted earlier suggests that such
labor is not in vain.

To
prove assertion number 2, we need only rely on the fact that the costs of
actively managing a given number of dollars will exceed those of passive management.
Active managers must pay for more research and must pay more for trading.
Security analysis (e.g. the graduates of prestigious business schools) must
eat, and so must brokers, traders, specialists and other market-makers.

Because
active and passive returns are equal before cost, and because active managers
bear greater costs, it follows that the after-cost return from active
management must be lower than that
from passive management.

This
proves assertion number 2. Once again, the proof is embarrassingly simple and
uses only the most rudimentary notions of simple arithmetic.[68]

2)
The Race Horse Analogy.

Another way of explaining the
success of low-cost investment management is by focusing on the burden of fees
and costs. Generally (but not always), passively managed funds have lower fees
and costs than actively managed funds.

What is the consequence of high fees
and costs? It requires outperformance simply to “break even,” and even more
outperformance to “pull ahead.”

For example, imagine a racehorse in
a race. In nearly all horse races the combined weight of the jockey, saddle and
other tack is the same. Lower-weight jockeys must place weights in locations
near the saddles to make it a fair race.

Now imagine that one racehorse is
given an extra 25 pounds of weight, relative to all other race horses. Will
that racehorse be unable to win in a relatively short race, lasting just 3/4ths
of a mile? Not necessarily – that racehorse may have a favorable starting
position, an excellent start, or indeed may have better performance. The
likelihood that such racehorse will win is only marginally lower.

But now imagine that the races get
longer, and longer. The added 25 pounds of weight begins to take its toll. It
becomes harder and harder for the racehorse with the added weight to prevail in
these longer races. Not impossible, but just much harder.

And so it is with the added fees and
costs of active management. In such instance, the longer the race (i.e., the
greater the number of years surveyed), the ongoing fees and costs take their
toll, and the higher-fee stock mutual fund or ETF is unlikely to prevail, and
often may struggle to even survive.

3)
The Academic Research Prior to 2012.

Many
investors are willing to pay higher fees with the hope of earning a higher
return. However, the academic research prior to 2012 generally supports the
conclusion that higher-fee, actively managed mutual funds are bested, on
average, by low-cost passively managed funds:

·Sharpe
(1966)[69] and
Jensen (1968)[70]
first showed that the average mutual fund underperformed relative to their
indexes.

·“Eugene
Fama, William Sharpe and Jack Treynor were some of the first researchers to
note the apparent lack of skill by mutual fund managers. Economist Michael
Jensen provided his view in 1967, that “mutual funds were on average not able
to predict security prices well enough to outperform a buy-the-market-and-hold
policy, but also that there is very little evidence that any individual fund
was able to do significantly better than that which we expected from mere
random chance.”[71]

·Actively
managed funds tend to underperform their benchmarks after adjusting for
expenses, and the probability of earning a positive risk-adjusted return is
inversely related to expense ratios. (Haslem et al., 2008).[72]

·Although
a small number of early studies find that mutual funds having a common
objective (e.g., growth) outperform passive benchmark portfolios, Elton,
Gruber, and Blake (1996)[73] argue
that most of these studies would reach the opposite conclusion if survivorship
bias and/or adjustments for risk were properly taken into account.

·Opportunity
costs exist due to cash holdings by funds. Hence, part of this underperformance
is because actively managed mutual funds have higher liquidity needs for
frequent purchases and redemptions. (O’Neal, 2004).

·Evidence
collected over an extended period on the performance of (open-ended) mutual
funds in the US (Jensen, 1968[83];
Malkiel, 1995[84];
Wermers et al., 2010)[85] and
unit trusts and open-ended investment companies (OEICs) in the UK (Blake and
Timmermann, 1998[86];
Lunde et al., 1999)[87] has
found that on average a fund manager cannot outperform the market benchmark and
that any outperformance is more likely to be due to luck rather than skill.

·As
a result of lower expenses, broad index funds tend to outperform actively
managed funds with equivalent risk. Therefore, the best way for most investors
to improve performance is to have a broad index fund with minimal costs
(Malkiel, 2003).[88]

·As
stated in a 2011 paper, using data on active and passive US domestic equity
funds (the sample included a total of 13817 funds while the CRSP Mutual Fund
Database) from 1963 to 2008, the authors observed: “Similar to others, we first show that fees are an important determinant
of fund underperformance – that is, investors earn low returns on high fee
funds, which indicates that investors are not rewarded through superior
performance when purchasing ‘expensive’ funds. We explore a number of
hypotheses to explain the dispersion in fees and find that none adequately
explain the data. Most importantly, there is very little evidence that funds
change their fees over time. In fact the most important determinant of a fund’s
fee is the initial fee that it charges when it enters the market. There is
little evidence that funds reduce their fees following entry by similar funds or
that they raise their fees following large outflows as predicted by the
strategic fee setting hypothesis. We also
do not find evidence that higher fees are associated with proxies for higher
service levels provided to investors. Overall, our findings provide little
evidence that competitive pricing exists in the market for mutual funds.”[89] (Emphasis added.)

·Blake,
2014 (UK): Average Fund Manager in UK Unable to Deliver Outperformance Using
Either Selection or Market Timing.
“[U]sing a new dataset on equity mutual funds [returns from January
1998–September 2008] in the UK … [we] find that: the average equity mutual fund
manager is unable to deliver outperformance from stock selection or market
timing, once allowance is made for fund manager fees and for a set of common
risk factors that are known to influence returns; 95% of fund managers on the
basis of the first bootstrap and almost all fund managers on the basis of the
second bootstrap fail to outperform the zero-skill distribution net of fees;
and both bootstraps show that there are a small group of ‘star’ fund managers
who are able to generate superior performance (in excess of operating and
trading costs), but they extract the whole of this superior performance for
themselves via their fees, leaving nothing for investors.”[93]

·Ferri
and Benke (2012). Using the “CRSP Survivor-Bias-Free US Mutual
Fund Database … maintained by the Center for Research in Security Prices
(CRSP®), an integral part of the University of Chicago Booth School of Business
… In all portfolio tests, there was some benefit to using low-cost actively
managed funds, but not as much as we expected, given the reported impact that
fees have on individual fund performance. The probability of outperformance by
the all index fund portfolios remained above 70% in all scenarios … We
speculate that filtering actively managed funds may shift the probability curve
closer to an all index fund portfolio as in the low-expense example, but we are
not convinced that any filtering methodology will significantly alter the balance
in favor of all actively managed funds. This may be an area for future research
… A diversified portfolio holding only index funds in all asset classes is
difficult to beat in the short-term and becomes more difficult to beat over
time. An investor increases their probability of meeting their investment goals
with a diversified all index fund portfolio held for the long term.”[94]

·SPIVA
Scorecard (For Period Ending 12/31/2014). The S&P Dow Jones SPIVA® U.S. Scorecard is an
extensive report that’s published semiannually at mid-year and year-end. SPIVA
divides mutual fund return data into category tables covering different asset
classes, styles, and time periods. There’s also a measure of survivorship bias
and style drift for every category over each period. This accounts for funds
that are no longer in existence or have had a change in investment style. The
SPIVA® U.S. Scorecard Year-End 2014 has data going back 10 years. Excerpts from
this report follow:

·“It
is commonly believed that active management works best in inefficient
environments, such as small-cap or emerging markets. This argument is disputed
by the findings of this SPIVA Scorecard. The majority of small-cap active
managers have been consistently underperforming the benchmark over the full
10-year period as well as each rolling 5-year period, with data starting in
2002.”

·“Funds
disappear at a meaningful rate. Over the past five years, nearly 24% of
domestic equity funds, 24% of global and international equity funds, and 17% of
fixed income funds have been merged or liquidated. This finding highlights the
importance of addressing survivorship bias in mutual fund analysis.”[95]

Hence, to the extent investment
advisers believe, under the BIC exemption, that they can recommend higher-cost
products that pay their firm more than substantially similar low-cost
investments, with no harm to the client, these investment advisers are not
acting as expert advisers with the due care required of a fiduciary. The
academic evidence is compelling that higher-cost products possess a heavy
burden which, on average, negatively affects returns.

Divided
Allegiance and Loyalties = Inability to Instill a True Fiduciary Culture Within
a Firm.

I would also observe that some
commentators have been stating, publicly, that suitability is “97% of the way
there” to the fiduciary standard of conduct. This could not be further from the
truth. Even with the relaxation of the sole interests standard under the BIC
exemption to the best interests standard, as proposed, there remains a key
distinction – i.e., whom does one
represent? There is a huge gulf between representing a brokerage firm and/or
product manufacturer, versus representing the client. The mindset of the adviser
is completely different, as are the adviser’s loyalties.

Moreover, SIFMA’s and FINRA’s recent
attempt to re-define “best interests” standard as a different version of
suitability, discussed in a previous section of this comment letter, clouds the
issues even further and risks further confusion for both individual advisers
and their clients.

While the BIC exemption proposed by
the U.S. Department of Labor seeks to levelize the compensation to the
individual adviser, the brokerage firm or insurance company is still permitted
to possess higher, differential compensation for the sale of some products
relative to other similar products which might be available. Yet, under a
fiduciary standard, both the investment adviser and the firm possess broad fiduciary
duties toward the client.

While the fiduciary duty of loyalty
also extends from the investment adviser to the firm, when the fiduciary duty
of loyalty to the client also exists the duties are ordered. In other words,
the interests of the client are paramount, and the duty of loyalty owed by the
investment adviser to the firm are subordinate to the duty of loyalty owed to
the firm. The client’s best interest can, and should, remain paramount in the
eyes of both the firm and the individual adviser.

Is it realistic to believe, as
required under the BIC exemption, that firms will not seek to influence their
advisers to sell investment products which result in higher compensation to the
firm (but not to the adviser)? The long history of fines on various brokerage
firms and other product providers who repeatedly push propriety products
suggests that brokerage firms are unlikely to put forth pressure on advisors,
whether explicit or by other means.[96] It is
easy to surmise that some brokerage firms view such fines as a “cost of doing
business” and are likely to continue to put pressure, directly or indirectly,
on their sales representatives, especially given the substantial economic
incentives for the firms resulting from the sale of higher-cost products.

Modifications
to the BIC Exemption are Recommended in Order to Increase Consumer Protections.

Given the DOL’s relaxation of the
sole interests requirement and prohibited transaction rules under the BIC
exemption, and the inherent difficulties in determining whether the fiduciary
has been improperly motivated by his, her, or the firm’s own economic
self-interest in recommending a higher-cost product over a lower-cost product,
I suggest several modifications which might be undertaken to the BIC exemption
in order to strengthen same, in the sections that follow.

Given the extensive academic
evidence in support of the proposition that higher-fee investment products
result in lower-returns, and given the academic evidence in support of the
proposition that the skill of an outperforming investment manager cannot be
judged accurately until decades of performance history exist, the availability
of the BIC exemption should be questioned, to the extent such exemption permits
higher compensation for brokerage firms and insurance companies.

Differential compensation to the
firm creates, as expressed above, a perverse economic incentive for the firm. While
not a per se violation of a “best
interests” fiduciary standard, given all of the academic evidence in support of
the proposition that higher-fee investment products are highly likely to
underperform lower-fee investment products with the same characteristics (e.g.,
the same asset class), the bar for receipt of higher compensation should be set
high. Given the foregoing, the standard of due care should be expressly set
forth, and the burden of proof for adherence to such standard should rest, in
any legal (judicial or arbitration) proceedings, with the firm and the adviser.

It must be noted that an ERISA
fiduciary is held to the standard that a prudent person “acting in a like
capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims”, 29 U.S.C. §1104(a)(1)(B).
As such, the investment adviser and his or her firm are effectively held to the
standard of a “prudent expert.” The U.S. Department of Labor should make it
clear that this “prudent expert” standard is applicable under the BIC
exemption.

Furthermore, I recommend that the
U.S. Department of Labor adopt, under the BIC exemption, that for any
proceedings brought against the adviser and/or the firm, that the adviser and
firm bear the burden of proof that both procedural and substantive due
diligence were followed in the selection of the investment products.

While broker-dealer firms and
insurance companies may complain that such shifting of the burden of proof is
unwarranted, I believe sufficient academic evidence, as well as logical
principles, exists to warrant the conclusion that the burden of proof should be
shifted whenever differential compensation arrangements for the adviser or his
or her firm exist.

The U.S. Department of Labor may
desire to restrict the application of this shifted burden of proof to cases
where differential compensation exists. It is relatively easy for firms to
adopt a level-compensation methodology, thereby eschewing the perverse economic
incentives that result from differential compensation arrangements. For
example, in the release of the proposed BIC Exemption, Example 3 illustrates
fee offsets. Of course, other requirements must still be met, including the
“best interests” requirement within the Standards of Impartial Conduct, as well
as the requirement that the compensation be reasonable, as well as the other
requirements set forth in the exemption.

In addition, I recommend that U.S.
Department of Labor expressly state that Daubert
standard of reliability (for the admission of expert testimony) is applicable
to all proceedings (including but not limited to arbitration) in which either
party seeks to address whether or not the fiduciary duties of the firm and/or
the adviser has been met.

In this regard, purely qualitative
assessments of investment products are inherently speculative and would not
meet the requirement of the adviser and firm to act as a prudent expert.

Rather, the selection of the
investment product, when differential compensation arrangements exist, should
be undertaken on the basis of either extensive back-testing, or commonly
accepted academic evidence, or both, under the Daubert standard.

The DOL should highlight what its
“best interests” fiduciary standard requires when a conflict of interest is
present. The receipt of additional compensation, beyond that which would be
secured under the lowest-compensated available, where differential compensation
is permitted, is perhaps the most egregious of the possible conflicts of
interest. If, as the BIC Exemption permits, such differential compensation is
to be permitted, then investment advisers and their firms should be cautioned,
by the DOL, on the steps required to properly manage such a conflict of
interest.

These steps include, when a conflict
of interest is present:

First, disclosure of all material facts, which by
definition include disclosure of any and all conflicts of interest, and which
also includes disclosure of the existence of alternative products that are available,
either through the investment adviser or in the marketplace, which would result
in lower compensation to the fiduciary;

Second, that communication to the client must take
place to ensure that the client understands the material facts, including the conflict
of interest and its ramifications for the client, that such communication must
be affirmative (not simply providing access to certain documents), and that the
adviser has taken reasonable steps to ensure that the client has understood the
material facts (including ramifications for the client);

Third, that the client must provide informed consent to
any conflict of interest that are not avoided, recognizing the fundamental
principal that no client would ever consent to be harmed (and, as a best practice,
it is wise to secure the client’s informed consent in writing);

Fourth, that even with informed consent, the proposed
transaction must be and remain substantively fair to the client.

I further believe that the DOL
should require that the foregoing methodology for properly managing conflicts
of interest be included in each firm’s Code of Ethics, and that annual training around this
all-important methodology be required for any individual adviser who relies
upon the BIC exemption.

The issue of what constitutes
“reasonable compensation” is a complex one. For example, over the past 15 years
asset-based fees charged by brokers (under wrap accounts) and by registered
investment advisers (when charging as a percentage of assets under management)
have generally fallen. Further competition in the marketplace as more fiduciary
advisers appear, as well as the continued application of technology and
increased ease of receipt of investment advice through the internet, will
likely continue to drive down asset-based fees. Hence, what is “reasonable”
compensation in one era may not be “reasonable” in a future era.

Additionally, the scope of the
services provided can be quite different. Many fiduciary investment advisors
bundle a range of financial planning services, and even concierge services and
tax return preparation, into asset-based fees charged for investment advisory
services.

And, of course, the size of the
account, in terms of dollar amounts, can affect the amount charged. It is quite
common for larger accounts to not pay the same percentage fee as smaller
accounts do, under asset-based compensation arrangements with fiduciary
investment advisers, due to the economies of scale present.

Hence, while I do not believe that
the U.S. Department of Labor should declare what constitutes “reasonable
compensation,” it would be proper for the DOL to provide examples of unreasonable
compensation.

For example, suppose a qualified
retirement plan participant seeks to rollover a $500,000 401(k) account into an
IRA account. The fiduciary adviser, under the BIC exemption, seeks to charge a
commission. If a single family of mutual funds were to be recommended, due to
breakpoints on the commissions paid on “A” class shares, falls to 2% for a
$500,000 investment.[97]

However, no breakpoint discounts are
typically provided on sales of many variable annuity products, nor for nearly
all equity indexed annuities and fixed annuities. This provides an economic incentive
to a broker-dealer firm and/or insurance company to recommend these products over
mutual funds. These economic incentives are powerful, as evidenced by the
substantial sales of these products despite their often-high fees and costs or
other unfavorable characteristics (see discussion below).

It would be easy for the U.S.
Department of Labor to illustrate that a 5% commission on a $500,000 variable
annuity sale, in conjunction with a rollover into an IRA account, amounting to
$25,000, would be “unreasonable.” (It should be noted that many variable
annuities and other types of annuities pay much higher commissions than set
forth in this example. I have encountered certain equity indexed annuities with
surrender fees – an indication of the size of the commission paid – of 10% and
higher, and even as high as 25% in one instance.)

While variable annuity products are
complex, as discussed in a later section, the product-specific due diligence on
investment products recommended by a firm and its advisers is often undertaken
at the firm level, resulting in the ability to spread out the costs of such due
diligence over many, many clients. While time required to explain an variable
annuity to a client in order to adhere to the obligation to ensure client understanding
of material facts may involve several hours of more time for the investment
adviser, this also would not justify an extraordinarily higher commission.
Fiduciary advisors deserve to be compensated as expert professionals, and such
professional-level compensation must be at all times reasonable.

As seen, one of the problems with
commissions is that, when the amounts involved are large, the up-front
compensation for the services provided can easily become unreasonable. For
example, for the sale of a variable annuity product, in which product-specific
and client-specific due diligence has been undertaken, the services might also
include the preparation of an investment policy, the selection of funds within
the annuity to meet the terms of that investment policy, and the completion of
paperwork necessary to attend to the IRA rollover and the making of the
investment. Yet, again, these services would clearly not justify the receipt of
a $25,000 commission in the $500,000 IRA rollover example above.

Under a fiduciary standard, for compensation
to be reasonable the timing for the receipt of such compensation should also be
tied to when the professional services are rendered. Compensation should not be
made for services to be rendered at some distant point in the future (such as
years into the future, for continued rebalancing of the portfolio or other
investment advice or services). This is because there is no assurance that the
advisor-client relationship will continue, nor is there any assurance that a
product once acquired will not be quickly disposed of by the client (due to
changed circumstances of the client or other factors).

Hence, continuing the example above,
a 5% commission paid upon the rollover of a $500,000 401(k) plan balance into
an IRA variable annuity, or $25,000 commission, would result in unreasonable
compensation. This is especially so since, in all likelihood, trailing fees are
likely to be paid to the selling firm on an annual basis (typically from 0.05%
to 0.80% annually), for at least several years, if not indefinitely.

Other examples can be provided by
the DOL. I suggest that the DOL empanel an advisory board, consisting of
fiduciary investment advisers, to develop further examples of unreasonable
compensation. And, the caveat should be stated that just because the percentage
amount of compensation provided under the BIC exemption does not arise to the
level of the examples which are illustrated does not mean that the compensation
is reasonable; each instance in which reasonableness of fees is challenged will
require a fact-based analysis to compare the circumstances then existing,
including the amount of services provided, to the compensation received.

It should also be noted that if the
fiduciary investment adviser and/or his or her firm is receiving ongoing
compensation, in the nature of 12b-1 fees or trails on annuity fees, then
continued services should be provided. Otherwise, the receipt of additional
compensation, without the provision of substantial advisory services, would
result in unreasonable compensation.

For example, merely acting as
custodian, and providing monthly statements as well as annual reports and
semi-annual reports to the client, without more, would be insufficient to
support a 0.25% annual compensation structure. There are fiduciary investment
adviser firms that provide full investment management services, including portfolio
rebalancing and tax loss harvesting, as well as ongoing due diligence of the
investment products the clients hold (which ongoing due diligence is required
of a fiduciary advisor through periodic re-examination of the products and
competing products), for a 0.25% annual fee.[98]

Where the adviser-client
relationship is terminated, but custodial services are still provided, it is far
more reasonable in such instances for a flat annual account administration fee
to be paid by the customer; any compensation received by the broker/custodian
which exceeds a reasonable account administration flat fee should be rebated to
the customer.

Some broker-dealer firms and
insurance companies might take the position that during the first year of a
client engagement much higher compensation is allowed under the BIC exemption,
if financial planning services (such as tax planning, estate planning
recommendations, reviews of property and casualty insurance, etc.) are
undertaken. Certainly more work is required in the first year to structure and
implement the investment portfolio for the client and to explain the investment
strategy and the characteristics of the investment products. However, it must
be remembered that we are dealing with IRA accounts and qualified retirement
accounts under the BIC exemption. While fees for investment advice can be
deducted (directly by the investment adviser, or indirectly via the product provider)
from such accounts, there is no provision in the law that permits fees to be
paid from those accounts for other services such as financial planning.[99]

As seen above, the receipt of
commissions by fiduciary investment advisers raise a number of issues relating
to unreasonable compensation. However, fiduciary advisers can shop for products
that pay lower commissions, or as many variable annuity contracts now provide
utilize fee structures that provide an ongoing investment advisory fee to the firm
and its investment adviser rather than an up-front sales load or commission.

I believe that the DOL has made a
good faith effort to ensure clients continue to receive advice, in an
investment advisory industry where half or more of investment advice is
delivered in association with the sale of investment products, rather than in
an advisory context where no substantial third-party compensation is received
by the investment adviser.

However, given the existence of non-level
compensation arrangements under the BIC exemption, economic incentives exist
that will result in non-adherence to all the requirements of the exemption. And
efforts will likely be made, such as SIFMA’s “best interests” proposal recently
advanced, to re-define the scope of fiduciary duties as far lesser obligations.

In a July 14, 2015 article, “Fees
vs. Commissions: Why An Old Debate Is New Again,” appearing at AdvisorPerspectives, long-time and
highly respected industry commentator Bob Veres observed:

[Recent
changes in the securities industry] are forcing us to revisit the ancient fees
versus commissions debate. New data and new circumstances have changed the
debate in powerful ways.

How?
Let’s start with the middle market. Historically, defenders of commissions have
persistently asserted that it’s impossible to deliver investment advice,
profitably, to middle-market consumers if you only charge fees for your
services …

If
you sell a small [e.g., approximately
$5,000] annuity and pocket a $300 commission, how is that more efficient than
receiving a $300 check from the client for your recommendation of comparable
mutual funds or ETFs?

Meanwhile,
advisors all around the country have been refuting this argument for decades
through their normal business practices. The Garrett Planning Network and
Alliance of Comprehensive Advisors have been working with non-wealthy clients
for years on a fee basis. More recently, the XY Planning Network of advisors
has been charging subscription fees to younger Gen X/Y clients who have far
more credit card debt than investible assets. This, at least, suggests that fee
compensation is compatible with the middle market and even with those who have
assets at all.

But
even granting the validity that sales is somehow more efficient than
fee-compensated advice when both are delivered face-to-face, we now have a
plethora of online advice platforms that are willing to deliver relatively
sophisticated investment services to non-wealthy customers on an AUM- (that is,
pure fee) basis. Middle market consumers can get investment services from
Betterment, Wealthfront or one of the competitors that are sprouting up like
mushrooms after a warm summer rain.

This
is a game-changer. You can no longer argue that someone has to charge
commissions in order to provide services to the vast majority of Americans …

Today,
it’s possible to look back over 35 years and see that there has, indeed, been a
visible migration among advisors and planners from commissions to fees … The
number of fee-only planners has grown from fewer than 100 during the
tax-shelter limited-partnership days to roughly a fifth of all advisors
registered with the SEC, according to the latest data compiled by Tiburon
Associates.

Many
dually-registered reps are now primarily compensated by an AUM revenue model,
and every independent broker-dealer has its own asset management platform to
serve them. According to the various broker-dealer surveys in the industry
magazines, fees represent the fastest-growing segment of broker-dealer revenues,
virtually across the board …

The
point here is that it is finally possible to identify a clear trend from
commissions to fees in the profession. Before, those on the commission side of
the debate might have challenged the idea that commissions are on the decline
as a component of advisor compensation, and argued that fees are not the future
of the profession. They can’t make that argument any more …

[There
still exist] advisors who are happily getting paid to recommend investment and
insurance solutions that, if those products stopped paying commissions, they
would never recommend as the optimal solution to their clients.

That
is the pernicious effect that sales commissions are having on our profession:
the quality gap between what consumers are getting when they pay commissions,
and what they would get if they pay for advice directly …

Can
you name any other profession that routinely allows its practitioners to accept
sales commissions for the sales of products?[100]

As Bob Veres alludes to, the
provision of investment advice has been in a state of transition for several
decades. In just the past decade the transition away from product sales to
fiduciary relationships in which fees are paid directly by the client has
accelerated dramatically. New deployments of technology have aided advisors
serve the middle class, and the increased competition among fee-only investment
advisers continues to drive down the level of compensation. All of these ARE is
an extremely important, and powerful, developmentS that better secure the
retirement security of Americans.

The DOL’s new proposed definition of
“fiduciary” will further accelerate the already rapid change away from
commissions and other third-party compensation to client-paid, professional
compensation arrangements.

However, the BIC exemption, which as
stated above permits differential compensation and hence provides an economic
incentive to maintain product sales, and the potential under pressure from the
industry for re-definition of important terms utilized in the BIC exemptions’
requirements, could slow down this evolutionary process.

While the BIC exemption is necessary
at the present time in order to not disrupt the availability of advice to
Americans, and while the BIC exemption is workable in its current form, the
U.S. Department of Labor should not make the BIC exemption permanent. With sufficient
advance notice, product providers can and will change the structures of their
products in order to eliminate the many conflicts of interest that firms and
their representatives might otherwise possess, and both firms and advisors can
adjust to these changes.

Additionally, certain product-based
compensation arrangements, such as 12b-1 fees, possess troubling aspects. For
one, such fees are often (if not nearly always) received for services which are
advisory in nature; as a result 12b-1 fees are “investment adviser fees in
drag” and are subject to legal challenge as non-permitted “special
compensation” under the broker-dealer exception to the definition of investment
adviser found in the Investment Advisers Act of 1940.

In addition, 12b-1 fees continue to
apply even if the adviser-client relationship is terminated. Moreover, such
fees are incapable of negotiation in many cases, and it could be argued that
such fees act as an impermissible restraint of trade. FINRA’s cap on 12b-1 fees
could be seen as a de facto industry
agreement on fees to be paid; in other fiduciary contexts, such as fees
established by statute for certain legal services, such laws and/or regulations
have been overturned as unreasonable restraints of trade.

Hence, necessary evolution is
required in the product manufacturing industry to eliminate 12b-1 fees. The SEC
has recently stated that it is again studying the issue of 12b-1 fees.

In summary, many concerns exist that
the BIC exemption will wind up being diminished by industry pressure to
interpret terms, such as “best interests,” in some new manner. In addition, the
receipt of differential compensation leads to perverse economic incentives. Accordingly, I STRONGLY recommend that the
U.S. Department of Labor automatically sunset the BIC exemption, in order that
ERISA’s sole interests standard and prohibited transaction rules are then
applied (barring the application of some other existing prohibited transaction
exemption), on December 31st of a year which is 5-6 years following
the effective date of any final rule.

This 5-6 year period will permit an
adequate period of time for both the investment product manufacturers,
broker-dealer firms, and individual advisors to adjust their compensation
arrangements in order that ERISA’s sole interests requirement can be applied.

As stated above, the fiduciary
standard acts as a restraint upon greed. There is no need for the government to
permanently modify ERISA’s “sole interests” fiduciary standard of conduct in
order to fit the existing business models of broker-dealer firms and insurance
companies. However, the BIC exemption can be justified as a temporary transitional
standard for those advisers unable at the present time due to the numerous
often-hidden flows of revenue from product providers to product sellers.

In no event, however, should the BIC
exemption become permanent, as the economic incentives for differential
compensation provided by the BIC exemption, even with the changes recommended
above, will eventually lead to the BIC exemption becoming the rule, and not the
exception. Hence, an automatic sunset of the BIC exemption is essential.

As a professor teaching undergraduate
classes in both insurance and investments, I have often reviewed variable
annuity contracts with my students. Different contracts often use different
terminology for the same concepts. The array of available riders and choices
inside a variable annuity also contribute to their complexity. As a result,
much time is spent analyzing different variable annuity contracts, in order to
secure for the students an appropriate foundation for the analyses they will
undertake in the future.

What I have also seen is the sale of
variable annuities by many agents/registered representatives who fail to
understand the product itself – its fees, costs, potential benefits, and
limitations. For example, a common broker-sold variable annuity contract I
encounter contains a guaranteed minimum withdrawal benefit rider. With this
rider, the annual expenses of the annuity range from 3% to 4%, and perhaps
higher. This is broken down as follows, for the series of the variable annuity
that does notpossess an
up-front and substantial commission (paid via a deferred contingent sales
charge, or DCSC). A product that lacks a DCSC is more appropriate for a
fiduciary advisor, given the requirement of reasonable compensation):

1.10%Annual expense percentage for
the spousal highest daily lifetime income rider, a very

popular feature when this annuity is sold. Since this charge
is assessed on the greater of the actual account value or the “protected
withdrawal value,” when the actual account value falls below the protected
withdrawal value the effective annual expense percentage would be greater than
1.1%. Additionally, the insurance company can raise this annual charge to as
high as 2.0% a year.

0.91%, 0.92%, 0.94%, 0.94%, 0.95%, 0.99%
1.02%, 1.03%, 1.05%, 1.07%, 1.11%, 1.12%, 1.14%, 1.21%, 1.46%, and 1.59%. These
fund annual expense ratios assume the spousal highest daily lifetime income
rider is chosen, as noted above. When the rider is chosen, the fund selection
is limited by the terms of the contract; 10% must be allocated to the fixed
income account and the remaining 90% must be allocated to the insurance
company’s selected mutual funds, rather than the much larger universe of funds
permitted under the annuity contract if no lifetime income rider is chosen. The
interest rate on the fixed income account is determined by the insurance
company each year, based upon several factors, including the returns of the
insurance company’s general account. Each optional living benefit also requires
the contract owner’s participation in a predetermined mathematical formula that
may transfer the account value between the VA’s permitted sub-accounts and a
proprietary bond fund. It is assumed that the insurance company generates
revenue for itself on its fixed income account equal to the lowest annual
expense ratio of the available sub-accounts, for purposes of this analysis.
Most of these funds are “funds of funds” and include balanced funds (with
equity and fixed income allocations) or tactical asset allocation strategies.

and
principal mark-ups and mark-downs for bond trades. In addition, stock trades
incur

other transaction costs in the form
of bid-ask spreads, market impact, and opportunity costs due to delayed or
cancelled trades. In addition, fees are paid to an affiliate of the fund out of
a portion of any securities lending revenue. In addition, cash held by a fund
results in a different kind of opportunity cost. There is no method to estimate
the impact of these “hidden” fees and charges and costs, from publicly
available information. However, it is likely that these fees and charges and
costs vary from a low of perhaps 0.2% to a high of 1.0% (or even higher). For
purposes of this analysis, it is assumed that these fees and charges amount to
only 0.2%.

----Some
states and some municipalities charge premium taxes or similar taxes on
annuities.

The amount of tax will vary from jurisdiction to
jurisdiction and is subject to change. The current highest charge (Nevada) is
3.5% of the premiums paid. Often this premium tax, if assessed, is deducted by
the insurance company from the premium payment. However, for purposes of this
analysis it is assumed that there is no premium tax assessed.

Given the limited asset allocation
choices that are mandated by the insurance company if the spousal lifetime
benefit rider is chosen, it is likely that the gross returns (before any fees
and expenses) within the variable annuity would average 7.5% annually, over the
very long term, based upon long-term historical average returns of the asset
classes included in such funds. Yet, after deduction of fees of 4% (or greater)
(decreased to 3.5% or greater after the first 9 years), the net return to the
investor is likely to be only 3.5% over the long term, and perhaps even less.
However, for the first ten years of the annuity contract, the annuity contract
offers a “roll-up rate” of 5% (compounded) for the “protected value” – the
value if annuitization takes place. However, this 5% roll-up rate is terminated
if lifetime annuitization takes place during the first ten years.

While the annuity offers a
“guarantee” in the sense that, if lifetime annuitization is elected at a future
date, the highest daily value of the annuity will be used when applying the
annuitization rate, it is obvious that, given the high fees and costs of this
variable annuity it is highly unlikely that the variable annuity will reach a
high principal value over the long term. There simply exist too much extraction
of rents – fees and costs – for the sea encompassed within this variable
annuity to ever reach a good “high water mark” in most long-term market
environments. In fact, over a period of 20 years or longer, there is only a
very small probability that the variable annuity value, against which lifetime
annuitization is based, will exceed the rates of return on a balanced portfolio
of low-cost stock and bond funds (even assuming investment advisory fees and
fund fees for such a balanced portfolio totaling 1% a year). Hence, for
longer-term investors, the “guarantee” is often illusory.

Additionally, the annuitization rate
offered by the insurance company is quite low, compared to the rates for
immediate fixed income annuities from insurance companies with excellent
financial strength on the marketplace today. This is true even though
annuitization rates offered today are quite low, relative to those historically
offered, due to the low interest rate environment of today. Here’s a
comparison:

As seen in the table above, the client would typically
be far better off shopping for a single premium immediate annuity in the
marketplace. Even purchasing a charitable gift annuity, in which the American
Council on Gift Annuities targets a residuum (the amount realized by the
charity upon termination of an annuity) of 50% of the original contribution for
the gift annuity, would usually be better. And, as noted above, if
annuitization is to occur in the future, it is highly likely that today’s
extremely low interest rate environment would moderate, resulting in even
higher annuitization rates at that time.

Given this substantial limitations
of this variable annuity product, it is difficult to see how any fiduciary
investment adviser who, after performing due diligence on variable annuities
such as this one, would recommend it to a client with a long-term investment time
horizon. Other investment strategies and solutions exist which are highly
likely to generate outcomes much more favorable to the client over the client’s
lifetime.

Even more rare is the client who
understands the variable annuity he or she has purchased. In fact, for
broker-sold variable annuities, in all my years of practice I never met a
client who, having already been sold a variable annuity with these or similar
features, came close to fully understanding the features of the variable
annuity, and the often-illusory nature of the “guarantee” provided. Most
clients assume that the guaranteed value will be available if the full amount
is withdrawn in full; hardly any clients realize that the variable annuity must
be annuitized, over lifetime, at a relatively low annuitization rate. And none
of the clients I met understood the high level of fees and charges assessed
against the annuity account value (or, worse yet, the higher protected value,
as to some of the percentage fees charged).

It is the obligation of the
fiduciary investment adviser to understand the product he or she is selling,
and to fully explain all material aspects of the contract to the client. Hence,
I suggest that the U.S. Department of Labor, in its issuing release, remind
investment advisers of their fiduciary obligation of due care when dealing with
variable annuities. The investment adviser should be able to comprehend, and be
able to effectively explain to the client in a manner which ensures client
understanding, many concepts relating to variable annuity products, including but not limited to the following:

1)there
is no tax advantage for holding a variable annuity in a traditional IRA, Roth
IRA, 401(k), or other qualified retirement plan;

2)the
client should normally not purchase a variable annuity with funds that the
client will likely need for current (or near-term) expenses;

3)that
withdrawals from the annuity before the client attains age 59-1/2 may be subject
to a 10% federal penalty tax [and ways to avoid such penalty, such as 72(t)
elections, rollovers to qualified retirement plans possessing age 55 withdrawal
rights without penalty, etc.];

4)the
computational methods utilized in determining any guaranteed amounts which
might be available either upon the death of the annuitant(s) or upon
annuitization, and the nature of each guarantee and any limitations on when the
guaranteed amounts are secured;

5)the
annuity’s various fees and expenses, including but not limited to annual
mortality and expense charges (and whether fees/costs vary), annual
administration expenses, contingent deferred sales charges, expenses associated
with any riders (enhanced death benefit, GMWB, etc.) provided under the
contract, the annual expenses of the variable annuity’s sub-accounts, and their
composition, including management fees, administration fees, and 12b-1 fees;
the brokerage commissions paid (due to transactions occurring within the funds)
by any subaccounts recommended to the client, as a percentage of the average
net asset value of the subaccount, and whether such brokerage commissions are
paid to the insurance company or its affiliates and/or to any firm associated
with the investment adviser or affiliates of such firm, and whether such
brokerage commissions include any soft dollar compensation; securities lending
revenue obtained by such subaccount and the extent to which the gross security
lending revenue is shared with the investment adviser or any other service
provider and whether such service providers are affiliated with the insurance
company or the investment adviser’s firm or any of their affiliates; additional
transaction and opportunity costs resulting from securities trading within the
fund, the subaccount’s annual turnover rate (computed as the average of sales
and purchases within the fund divided by average net asset value of the fund);
the percentage of cash holdings of the subaccount over time and the likely
resulting opportunity costs arising therefrom;

6)the
financial strength of the insurance company and the importance of such
financial strength, especially during a period of annuization;

7)the
rate of return of the variable annuity’s fixed account, the exposure of fixed
account assets to the claims of the general creditors of an insurance company
upon default; whether state guaranty funds likely protect against a default by
the insurance company and if so to which extent; whether different annuities
should be purchased – from different companies – to better protect against the
risks of insurance company default; the likelihood of insurance company default
on a historical basis given the starting financial strength of the company as
measured by the various rating agencies; the Comdex score for the insurance
company;

8)the
impact of fees and costs of the variable annuity contract on the account value
of the variable annuity, and the availability of and any limitations on the
various guarantees offered by the insurance company either as a core of the
policy or as a rider;

9)an
estimate of the likely long-term rate of return of the variable annuity
contract, as structured by the investment adviser, versus the likely long-term
rate of return of alternative investment strategies and alternate products
(including alternate variable annuity products), and an estimate of the likelihood
that the protected value of the annuity will be higher than the returns of
non-guaranteed products, over various time periods;

10)the
annuitization rates offered under the annuity contract, whether those rates are
guaranteed, how these rates may change over time, how these rates compare to
similar single premium lifetime annuity rates in the marketplace, and the
negative or positive effective rate of return the client(s) will receive during
the annuitization period assuming death of the client(s) occur at various ages.

11)any
options existing for spousal lifetime annuitization and/or term certain, or any
combination thereof, and how these options should be considered given the
medical history of the clients and their family members;

12)whether,
during annuitization, the client would be better served by annuitization of a
portion of the client’s portfolio, whether an annual inflation increase would
better serve the client in terms of providing needed lifetime income, whether
there exist optimal ages or times (from the date of purchase of the annuity
contract) to consider undertaking annuitization, and whether a ladder of
annuitized investments undertaken over time, at various ages, would better
serve the client;

13)for
nonqualified annuities: the taxation of withdrawals from the annuity contact,
the lack of long-term capital gain treatment, the lack of stepped-up basis upon
the death of the account holder(s), and the withdrawals mandated by heirs of
the annuitant(s) and the combined estate tax / federal income tax / state
income tax consequences of income in respect of a decedent; and how withdrawals
from such nonqualified annuity contract might be undertaken to take advantage
of any lower marginal income tax brackets (both during lifetime of the
annuitants, and as to beneficiaries); and the impact of withdrawals on related
income tax planning issues for a client including taxation of social security
retirement benefits, the amount of Medicare premiums paid, and alternative
minimum tax computations; and the taxation of principle and income upon
annuitization of the nonqualified variable annuity contract; the lack of
foreign tax credit availability to the client when foreign stock funds are
utilized as subaccounts of the variable annuity;

14)the
impact of any cash withdrawals upon any guarantees or features of the variable
annuity contract;

15)the
various risks attendant to the investments in any fixed income account or the
subaccounts in the variable annuity; and

16)the understanding that higher cost
investments nearly always result in lower returns for investors over the long
term, relative to lower cost investments that are substantially similar in
composition and risk exposures.

I recommend that the prohibited
transaction relief for the receipt of sales commissions has been available
under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary”
insurance advisors of equity indexed annuities (EIAs) to ERISA plans and to
IRAs be repealed, not modified. I further recommend that the BIC exemption
apply to the sale of equity indexed annuities, but that the BIC exemption be
modified to reflect that disclosure of the costs of the EIA cannot be
undertaken with any accuracy, and instead that the compensation to the
fiduciary investment adviser be disclosed with particularity. This
recommendation is undertaken as a means of consolidating the regulatory regime and
providing further guidance and instruction to insurance agents over time (as,
no doubt, cases and notices will be published regarding the BIC exemption over
time). Additionally, while the insurance industry will argue that equity
indexed annuities are “insurance products” (in the sense that they are not
regulated as securities), from the consumer perspective such equity indexed annuities
are an “investment” – similar to the consumer perception that a bank-issued
certificate of deposit is also an investment.

In addition, equity-indexed
annuities (EIAs), also known as fixed indexed annuities, are another product
that, in my experience, many investment advisers and the clients who purchase
them do not fully comprehend.

The fiduciary investment adviser
should be able to understand EIAs, and be able to effectively explain the many
features of these products to the adviser’s client. This includes, but is not limited to, the following:

We have observed that most
purchasers of EIAs gain little understanding of many of the material facts
surrounding these products. A fiduciary advisor must not only disclosure these
material facts, but must also ensure client understanding of them. These
include:

1)That the EIA imposes a penalty,
similar to a surrender charge, for early withdrawals from the annuity, whether
any portion of the funds can be withdrawn from the EIA each year without a penalty,
the amount of the surrender charge and when it disappears, and that withdrawals
from the EIA are best undertaken at particular points during each contract
year.

2)That investments in an EIA are not
meant for funds which are likely to be utilized by the client to address
short-term financial needs.

3)That the dollar value of the annuity
shown on the client’s statement is not the “market value” of the annuity as it
relates to the client, but rather the “surrender value” (unless these are
separately stated and appropriately marked on each statement).

4)That the amount of the credit provided
to the client during any period for index returns during each period does not
include dividends which would have been received by an index fund tied to that
index and which would otherwise have been be reinvested in that index; how the
dividend rates for the index have fluctuated over time; the current dividend
rate for the index; and if in the future dividend payout rates are higher due
to changes in U.S. federal income tax policy, or due to other factors (such as
shareholder demand for payment of dividends, versus retention thereof), the percentage
of index total returns the client receives could be significantly impaired by
the fact of the exclusion of dividends.

5)That the amount of the credit
provided to the client during any period in which the client elects to tie
returns to those of an index is further limited by a cap on the index returns;
that this cap limits the amount of interest credited to the client’s annuity
contract; the current cap and the cap in recent years; whether the insurance
company has lowered the cap since the inception of the annuity contract (for
any purchaser thereof) and when; and that the insurance company reserves the
right to lower such caps, which would negatively affect the client’s returns;

6)That the amount of the credit
provided to the client during any period in which the client elects to tie
returns to those of an index is further limited by the participation rate; the
current level of the participation rate; the past levels of the participation
rate; and that the insurance company reserves the right to lower the
participation rate, which would negatively affect the client’s returns.

7)That the amount of the credit
provided to the client during any period in which the client elects to tie
returns to those of an index is further limited by is further limited by market
value adjustments, which should be able to be described with particularity, and
that such market value adjustments may negatively affect the client’s returns;

8)That the amount of the credit
provided to the client during any period in which the client elects to tie
returns to those of an index is further limited by is further limited by the
imposition (annually) of “administrative charges,” whether the insurance
company reserves the right to increase the administrative charges; whether such
administrative returns are capped; the current level and historical level of
the administrative charges, and that such administrative charges negatively
impact the client’s returns;

9)That the funds placed with the
insurance company are part of the insurer’s general account and subject to the
general claims of the insurance company’s creditors; unlike a mutual fund or
variable annuity sub-account your annuity funds are not segregated and
therefore the client’s funds are not protected in the event of
insolvency of the insurance company; the financial strength ratings of the
insurance company including its Comdex score; whether any state guaranty funds
exist to safeguard investors and the extent of such guarantees; whether such
state guaranty funds would apply should the client’s state of residence be
changed; and the fact that state guaranty funds exist at this discretion of the
states’ legislatures.

10)The default rate, over the past 10,
20, 30, 40 and 50 years or more, of insurance companies, based upon their
initial financial strength rating;

11)That various tax proposals exist
which, if they were to be enacted, could adversely affect the commercial
viability of many life insurance and annuity products, which in turn could
significantly impair the ability of many insurance companies to meet their
obligations to their present insurance policy holders and annuity contract
owners;

12)That for nonqualified EIAs any
withdrawals from the annuity of gains within the annuity will be taxed at the
client’s ordinary income tax rates, that gains are distributed prior to the
return of principal (unless annuitization occurs); that the client will not
receive the more favorable long-term capital gain treatment that would have
been available through a tax-efficient or tax-managed stock mutual fund; and that
no stepped-up basis exists upon the death of the annuitant (and the
consequences of same, to heirs);

13)That for EIAs held in IRA accounts, tax
deferral is already provided by the IRA account possessed, and hence is not a benefit
of this annuity contract; similarly, for EIAs held in Roth IRA accounts,
tax-free growth of principal is a feature of the account and not of the annuity
contract.

Over 20 years ago I was approached
by a client who had his entire qualified retirement plan balance (approximately
$400,000) rolled over into a fixed tax-deferred IRA annuity. The client
requested my opinion regarding the safety of the investment. After conducting
an investigation into the financial strength of the insurance company that
issued the fixed annuity, I determined that the fixed annuity was issued by a
very low-rated insurance company, that state guarantees at the time were
insufficient to protect the client’s investment in the annuity contract, and
that the client should withdraw a significant portion of the annuity (and incur
a significant surrender fee, then 9% of the amount withdrawn) in order to
better safeguard the client’s hard-earned retirement savings.

Unfortunately, lower-rated insurance
companies often offer higher commissions to insurance agents to sell their
insurance products, including annuities. As a result, the insurance agent often
possesses an economic incentive to recommend not among the best of the fixed
annuity products available, but among the worst. The application of fiduciary
duties, along with other measures I recommend herein, under the BIC exemption,
should go a long way to counter these perverse economic incentives.

I recommend that the prohibited
transaction relief for the receipt of sales commissions has been available
under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary”
insurance advisors of fixed insurance products to ERISA plans and to IRAs be
repealed, not modified. I further recommend that the BIC exemption apply to the
sale of fixed annuities, but that the BIC exemption be modified to reflect that
disclosure of the costs of the fixed annuity cannot be undertaken with any
accuracy, and instead that the compensation to the fiduciary investment adviser
be disclosed with particularity. This recommendation is undertaken as a means
of consolidating the regulatory regime and providing further guidance and
instruction to insurance agents over time (as, no doubt, cases and notices will
be published regarding the BIC exemption over time). Additionally, while the
insurance industry will argue that fixed annuities are merely “insurance
products” (in the sense that they are not regulated as securities), from the
consumer perspective such fixed annuities are an “investment” – similar to the
consumer perception that a bank-issued certificate of deposit is also an
investment.

Similar to EIAs above, the
investment adviser should be aware of the risks of insurance company default,
the financial strength ratings of the insurance company, the presence of state
guaranty funds and the limits and effect of a client’s change of residence, and
more. In addition, the investment adviser should be able to compare the rate of
return of the fixed annuity to other fixed income vehicles, weigh the varying risks
and returns of different forms of fixed income vehicles, and determine whether
diversification of fixed annuities among highly rated insurance companies as a
best practice given the client’s situation.

In addition, the fiduciary
investment adviser should be able to examine, and to explain to the client: the
benefits of a fixed annuity with an annual CPI increase during annuitization;
the impact of inflation upon the client’s purchasing power; whether laddering
of annuities over time presents a valid strategy; the liquidity (or lack of
liquidity) characteristics of the annuity either before or after annuitization;
and the effective rate of return for the client of an product annuitized over
one’s lifetime given the client’s attainment of certain ages.

XI. On the Regulation of
IRA Rollovers by Independent Advisers

When undertaking a rollover from an
ERISA plan to an IRA account, a great deal of care must be undertaken. This
requires any fiduciary adviser to possess a great deal of knowledge of the many
factors and tax rules which come into play, in order to ensure maximum benefits
to the individual client. In addition, a rollover into an individual IRA
account often involves a much higher level of service provided to the
individual investor, during and following the rollover process; as a result of
this differing level of service and the lack of economies of scale which are
often present in the defined contribution space, the compensation for
individual accounts is higher. Accordingly, this results in a potential
prohibited transaction, even for fee-only independent registered investment
advisers.

Any fiduciary adviser providing
advice on an IRA rollover should fully understand, and be able to apply, the
often-complex tax and other considerations that may affect the decision,
including but not limited to:

(1)the
availability under many qualified retirement plans (QRPs) to undertake
distributions commencing at age 55, rather than the age 59½ requirement imposed
upon IRAs;

(2)the
existence and best methods for undertaking a series of substantially equal
periodic payments from traditional IRA accounts using the 72(t) election;

(4)the
ability to distribute appreciated employer stock from certain QRPs and receive
long-term capital gain treatment upon its later sale, under the technique
commonly referred to as “net unrealized appreciation”;

(5)the
most tax-efficient manner to design, implement and manage a client’s entire
portfolio, which might consist of QRPs, traditional IRAs, Roth IRAs,
nonqualified annuities, life insurance cash values, taxable accounts, 529
college savings plans accounts, HSA accounts, and other types of accounts,
generally, in order to best secure for the client the likely attainment of the
client’s objectives;

(6)the
ability to undertake due diligence on the investment options within a QRP
account, including but not limited to the potential availability of guaranteed
investment accounts (and the risks and characteristics of same, including the
reduced exposure to interest rate risk which might be present);

(7)the
restrictions which exist on the availability of foreign tax credits and/or
deductions for foreign stock funds held in certain types of accounts;

(8)the
best manner to minimize future potential income tax liability for both the
clients and the client’s potential heirs, including the role of stepped-up
basis;

(10)the marginal rates of tax (federal,
state and local) which might be imposed upon ordinary income and long-term
capital gain income, and qualified dividend income, both in the current year
and in future years;

(12)the harvesting of losses in accounts
and how such losses may offset either various types of capital gains or
ordinary income (up to certain annual limits);

(13)whether Roth IRA conversions should
be considered, and if so when and to what extent, whether separate Roth IRA
accounts might be established during conversions for different investment
assets, and whether re-characterizations might take place thereafter;

(14)whether distributions might be
undertaken to generate additional ordinary income, in order to mitigate the
effect in any year of the alternative minimum tax;

(15)the increased amount of premiums for
Medicare Part A which might result should the client’s/clients’ modified adjusted
gross income exceed certain limits;

(16)the effect of additional income
resulting from QRP or IRA distributions, or from other investment-related
income, on the taxation of social security retirement benefits;

(17)the interplay between the timing of
taking social security retirement benefits, income tax itemized vs. standard
deduction strategies, the receipt of various forms of income, and the taking of
QRP or IRA distributions, given the various marginal income tax rates the
client is likely to possess, then and in the future, for both federal and state
tax purposes;

(18)the ability to take investment
advisory fees from certain types of accounts, the best methods to allocate fees
and pay them from various types of accounts, the potential for deductibility of
fees when paid from certain types of accounts, and avoidance of prohibited
transactions which might otherwise result if fees for non-investment advisory
services are incorrectly paid from QRP or IRA accounts;

(20)the availability of lifetime
annuitization options for a portion of any QRP or IRA, both inside the QRP and
in a rollover IRA, including an evaluation of the single life, spousal (with
and without reduced benefits to the survivor), term certain, and combinations
of the foregoing, and including further an evaluation of the possible use of
CPI adjustments in the annuity contract to keep pace with increased spending
needs, and including further the possible use of a staggered approach to
annuitization, and including further the available of deferred annuities with
payouts commencing at later ages, and including further the risks and return
characteristics of certain annuities, the costs and fees associated with same,
the possible applicability of premium taxes, the various riders which might be
employed and their costs and benefits and limitations; and

(21)the best method to ensure asset
protection of the rollover IRA, such as by segregating it from contributory IRA
accounts.

As to broker-dealers, dual
registrants, and insurance agents, the DOL’s requirements for the BIC exemption
(with modifications, as suggested above) seem wholly appropriate. The DOL might
seek, in its issuing release, to remind fiduciary advisers of the need for a
high degree of competence when planning for IRA rollovers and the extensive
knowledge required to provide advice on proper structuring of investment
portfolios to best secure the client’s retirement income needs over the long
term or to meet other objectives of the client.

However, for independent registered
investment advisers, who are not affiliated with any broker-dealer and who
receive no third-party compensation (i.e., compensation from providers of
investment products or insurance products), the requirements of the BIC
exemption (especially as to the requirement of no discretion) seem
inapplicable. These “fee-only” registered investment advisers already agree to
adhere to the tough “sole interests” standard found under ERISA and the
prohibited transaction rules when providing ongoing investment advice. The
conflict of interest that occurs is only in whether to undertake a rollover to
an IRA, where the fees paid by the client will be higher than those in the
qualified retirement plan account, such higher fees reflective of a higher
level of service provided.

Hence, I suggest that the DOL
promulgate a new prohibited transaction exemption for advice provided with
respect to rollovers from an ERISA-covered retirement plan to an IRA account.
This prohibited transaction exemption would be applicable only to independent
registered investment advisers who receive no cash payments from any
broker-dealer or insurance company. Under this prohibited transaction exemption
the following requirements would be imposed, over and above the fiduciary
requirements already imposed under ERISA and the various requirements of the
SEC and state securities administrators:

1)That
the independent investment adviser fully disclose to the client the difference
in the amount the client would pay in the estimated total fees and costs if
client continued in the client’s current qualified retirement plan account
versus the recommended rollover IRA, expressed both as a percentage of the
amount invested and as a dollar amount (estimated in good faith);

2)That
the independent investment adviser fully disclose to the client that the client
has other options, including self-managed IRA accounts, and that some options
will possess lower fees and costs; and

3)That the independent investment adviser
fully disclose to the client that the higher the total fees and costs
associated with investments and the delivery of investment advice, the lower
the return of the investor, on average, and that such lower returns can
significantly affect the size of the investment portfolio over the long term.

Again, this exemption would be
limited to independent fee-only registered investment advisers – i.e., those who receive no payments from
broker-dealer firms, insurance companies, or investment product manufacturers.
Upon the sunset of the BIC exemption, as suggested above, it would be
anticipated that all providers of rollover IRA advice would be able to adhere
to the “sole interests” requirements of ERISA and its prohibited transaction
rules, under this new proposed prohibited transaction exemption.

Since this would be a new PTE, and
it is relatively straightforward, I believe that this PTE could be proposed and
finalized under the normal timeline for agency rulemaking. There would be no
need to delay the rulemaking process for the DOL’s Conflicts of Interest Rule
and for the BIC exemption and other exemptions the DOL has proposed, simply as
a result of the promulgation of this new, simple and limited exemption.

The DOL has proposed an exemption
for non-fiduciary investment providers from the definition of fiduciary for
large retirement plans. In examining this proposed exclusion, attention should
be given to the effectiveness of large retirement plans to embrace the best
investment products.

As discussed earlier in this comment
letter, there exists a compelling body of academic research that low-cost
funds, such as passive investment vehicles (including but not limited to index
funds and index ETFs), outperform higher-cost funds, on average. The longer the
time horizon the greater the frequency, and amount, of the outperformance.

One would expect that large pension
funds, armed with savvy investment advisers, would flock to passive investing.
Yet, as reported in early 2015 by The Wall
Street Journal:

More
individuals are pouring money into so-called passive investing or index funds,
which aim to match the performance of the main stock and bond markets, but
larger institutions like pension funds and endowments have been slower to
follow suit, despite the potential for higher returns and lower fees.

These
bigger institutions still tend to rely on an army of asset managers and
consultants who charge higher fees but promise better returns through so-called
alternative investments like private equity and hedge funds. But many of these
investments do no better — or even worse — than index funds, opponents say.[101]

How
good are these consultants? Not very – they fail to add value. As reported by The Economist in March 2015:

Many
pension funds and endowments hire investment consultants to help them choose
fund managers (one estimate is that 82% of US pension plans use such services,
and consultants advise on $25 trillion of assets). The consultants employ
highly-educated workforces, have decades of experience and charge hefty fees.
But an academic paper, which was awarded the 2015 Commonfund prize, concluded:

we find no evidence that these (the
consultants') recommendations add value, suggesting that the search for winners,
encouraged and guided by investment consultants, is fruitless

…
The first point is how important these consultants are: the top 10 have an 82%
market share worldwide and are seen by most fund managers as the gateway to
clients. Despite this, there is very little data on how good the consultants
are at their jobs. For people who demand a lot of numbers from the fund
management profession, they release very little information themselves. However,
Greenwich Associates have conducted a survey of the consultants'
recommendations of American long-only equity funds from 1999 to 2011.The
surveys contain an annual list of fund managers showing what proportion of
consultants recommend each manager; it also asks the consultants why they do
so.

Interestingly,
the consultants do not merely chase past returns. This is not too surprising;
they are smart people and know the limitations of the data. They look at soft
factors such as investment style (is performance consistent with the stated
philosophy? can the manager explain trading decisions?) or service provision.
Despite all this, they conclude that

the portfolio of all products
recommended by investment consultants delivered average returns net of management
fees of 6.31% per year (7.13% before fees). These returns are, on average 1.12%
lower than the returns obtained by other products available to plan sponsors,
which are not recommended by consultants.

…
So if they can't pick winners, why do the consultants favour active managers at
all? After all, fees are higher than on passive products and clients are more
likely to switch managers on a regular basis, an activity that tends to reduce
returns.

The authors suggest that

Consultants face a conflict of
interest, as arguably they have a vested interest in complexity. Proposing an
active US equity strategy, which involves more due diligence, complexity,
monitoring, switching and therefore more consultancy work, drives up consulting
revenues in comparison to simple cheap solutions.[102]

As indicated, the view that larger
ERISA retirement plan sponsors don’t need the protection of the fiduciary
standard of conduct, and its imposition of a duty of due care as well as,
through the duty of loyalty, the avoidance of conflicts of interest, is highly
suspect.

Indeed, an ERISA plan sponsor and/or
its independent investment adviser would, if truly educated and informed, would
require any provider of investment recommendations to be a fiduciary.

Simply because an investment adviser
to a larger plan sponsor is “independent” does not, in and of itself, assure that
the investment adviser possesses adequate expertise to advise upon the
selection of investment options for the plan.

Accordingly, I recommend that this
proposed exemption be dropped from consideration.

Alternatively, I recommend that
educational requirements be established for the independent adviser to the
plan, who will be engaged in the selection of investment products offered by
non-fiduciary providers. Rather than specify a particular designation, I
suggest that a minimum number of hours of education, acquired through either
college-level (undergraduate or undergraduate) course work, or via
certification programs or seminar attendance, be required. Specifically:

An independent investment adviser should possess a
minimum of 90 hours of education from college-level (or higher) course work,
acquired through university, college, certification/designation training, or
other seminars for which continuing education credit in the area of investments
is provided by either the CFP Board of Standards, Inc., the AICPA, the IMCA, or
the CFA Institute, in which the following subjects are covered: (1) discerning
the fees and costs of investment products, including but not limited to the
impact of sales loads, transaction costs relating to securities transactions
occurring within a fund, and various opportunity costs which may be present;
(2) Modern Portfolio Theory; (3) the Efficient Markets Hypothesis; (4)
variable, equity-index and fixed deferred and immediate annuities, their fees
and costs, and their benefits and limitations, and understanding the various
guarantees and riders available; (5) the structure, characteristics, and fees
and costs of publicly traded REITs; (6) multi-factor investment strategies,
including but not limited to discussions of the value, small-cap, and
profitability factors; (7) ERISA and regulations promulgated thereunder; and
(8) the requirements of the fiduciary standard of conduct (of which a minimum
of 10 hours of instruction in this area, out of the total hours, must be
devoted).

Various objections to the DOL’s
proposal have been raised in the public sphere that differing fiduciary
standards may exist, between providing advice to accounts covered by the
Conflicts of Interest Rule and other types of accounts, and that compliance
with differing standards would prove too difficult. This is patently false and
non-sensible. It has long been understood by providers of services under two
different standards of conduct that the easiest path to ensure compliance is to
simply apply the higher standard to the entirety of the relationship.

Indeed, the SEC staff in 2011,
following in the footsteps of the Certified Financial Planner Board of
Standards, Inc.’s professional rules of conduct, explained that the federal fiduciary
standard applies to a fiduciary adviser’s “entire relationship” with clients
and prospective clients.[103] In
this regard, it must be understood that “contract
law concerns itself with transactions while fiduciary law concerns itself with
relationships.”[104]

While the DOL cannot, through its
own regulations, mandate the fiduciary standard applicable to non-ERISA and
non-IRA accounts, any “dilemmna” posed by the existence of differing standards
is easily solved, as set forth above. The highest standards applicable to any
account should govern the entirety of the relationship. This is likely the
perception the client will possess, and this solution follows upon accepted
common law that fiduciary status attaches to relationships, not accounts.

One must wonder why FINRA, in
existence for over 75 years, has not incorporated into its conduct rules for
brokers the requirements of a fiduciary standard, and acknowledge that under
certain circumstances (e.g., when a
relationship of trust and confidence is formed, when de facto discretion exists, etc.) that brokers can (and have been,
repeatedly) held to be fiduciaries under state common law. If FINRA is
concerned about the “confusion” that might exist among brokers and their
registered representatives about varying standards of conduct, the solution for
FINRA’s concern is very apparent: (1) simply copy into FINRA’s conduct rules
the fiduciary standards of conduct under DOL (or other) regulatory regimes; (2)
specify when such fiduciary standards of conduct apply (easily discernible from
the DOL’s proposals, and guided by established law in other areas); and (3)
instruct the broker and its registered representatives to simply apply the
highest standard of conduct imposed upon any account or any aspect of the
relationship to the entirety of the relationship.

Adherence to the highest standard
imposed, when differing standards exist, isn’t rocket science. FINRA’s protests
(and those of the broker-dealer industry associations such as SIFMA and FSI,
and those of many broker-dealers themselves) should be dismissed as meritless
and mere attempts to deny to Americans the important fiduciary protections they
deserve.

Again, I generally applaud the U.S.
Department of Labor’s effort to better secure for our fellow Americans their
retirement security, and in so doing result in lesser burdens upon government
in the future, which in turn will assist with future economic growth.

I hope that the suggestions included
herein will aid the DOL as it seeks to finalize the Conflicts of Interest rule
and the various new and modified PTEs associated therewith.

Should the U.S. Department of Labor,
I am more than happy to discuss these recommendations in person, to further
elaborate upon them, and/or to provide other assistance which may be desired as
the DOL continues down the path to provide a better future for all Americans.

[1]This comment letter reflects my personal
views. These views are not necessarily representative of the views of any
institution, organization, group or firm with whom I may be, or have been,
associated.

[11] FINRA generally explains its current version of the
suitability rule, FINRA Rule 2111, as follows: “FINRA Rule 2111 requires, in
part, that a broker-dealer or associated person ‘have a reasonable basis to
believe that a recommended transaction or investment strategy involving a
security or securities is suitable for the customer, based on the information
obtained through the reasonable diligence of the [firm] or associated person to
ascertain the customer's investment profile.’ In general, a customer's investment
profile would include the customer's age, other investments, financial
situation and needs, tax status, investment objectives, investment experience,
investment time horizon, liquidity needs and risk tolerance. The rule also
explicitly covers recommended investment strategies involving securities,
including recommendations to "hold" securities. The rule, moreover,
identifies the three main suitability obligations: reasonable-basis,
customer-specific, and quantitative suitability. https://www.finra.org/industry/faq-finra-rule-2111-suitability-faq#sthash.LWz8PjDs.dpuf (retrieved June 10, 2015).

[17]As stated by Professor Ripken: “[E]ven if we could
purge disclosure documents of legaleze and make them easier to read, we are
still faced with the problem of cognitive and behavioral biases and constraints
that prevent the accurate processing of information and risk. As discussed
previously, information overload, excessive confidence in one’s own judgment,
overoptimism, and confirmation biases can undermine the effectiveness of
disclosure in communicating relevant information to investors. Disclosure may
not protect investors if these cognitive biases inhibit them from rationally
incorporating the disclosed information into their investment decisions.
No matter how much we do to make disclosure more meaningful and accessible to
investors, it will still be difficult for people to overcome their bounded
rationality. The disclosure of more information alone cannot cure investors of
the psychological constraints that may lead them to ignore or misuse the information.
If investors are overloaded, more information may simply make matters worse by
causing investors to be distracted and miss the most important aspects of the
disclosure … The bottom line is that there is ‘doubt that disclosure is the
optimal regulatory strategy if most investors suffer from cognitive biases’ …
While disclosure has its place in a well-functioning securities market, the
direct, substantive regulation of conduct may be a more effective method of
deterring fraudulent and unethical practices.” Ripken, Susanna Kim, The
Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive
Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006;
Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.

[18]See Robert Prentice, Whither Securities
Regulation Some Behavioral Observations Regarding Proposals for its Future, 51
Duke Law J. 1397 (March 2002). Professor Prentices summarizes: “Respected
commentators have floated several proposals for startling reforms of America’s
seventy-year-old securities regulation scheme. Many involve substantial
deregulation with a view toward allowing issuers and investors to contract
privately for desired levels of disclosure and fraud protection. The behavioral
literature explored in this Article cautions that in a deregulated securities
world it is exceedingly optimistic to expect issuers voluntarily to disclose
optimal levels of information, securities intermediaries such as stock
exchanges and stockbrokers to appropriately consider the interests of
investors, or investors to be able to bargain efficiently for fraud
protection.” Available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397.

[19]Id. See also
Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC” (2003),
at p.18.

[24]Ripken, Susanna Kim, The Dangers and Drawbacks of the
Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation.
Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper
No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.

[29]SeeRestatement (Third) of Agency § 8.02 cmt. a (2006) (explaining that under duty of
loyalty, “an agent has a duty not to acquire material benefits in disconnection
with transactions or other actions undertaken on the principal’s behalf or
through the agent’s use of position”).

[31] Michoud v. Girod,
45 U.S. 503 555 (1846). The U.S. Supreme Court also stated in that decision:
“if persons having a confidential character were permitted to avail themselves
of any knowledge acquired in that capacity, they might be induced to conceal their
information and not to exercise it for the benefit of the persons relying upon
their integrity. The characters are inconsistent. Emptor emit quam minimo potest, venditor vendit quam maximo potest.”
Id. at 554.

[32]SEC v. Capital Gains Research Bureau,
375 U.S. 180; 84 S. Ct. 275; 11 L. Ed. 2d 237; 1963 U.S. LEXIS 2446 (1963). The
principle is also found in early Christianity: “Christ said: ‘No man can serve
two masters, for either he will hate the one and love the other, or else he
will hold to the one and despise the other. Ye cannot serve God and Mammon
[money].’" Beasley v. Swinton,
46 S.C. 426; 24 S.E. 313; 1896 S.C. LEXIS 67 (S.C. 1896), quoting Matthew 6:24.

[35] These steps, and
legal authority for these requirements, are contained in my prior 2011 comment
letters.

[36]SIFMA announced a “best interests” proposal in late May 2015,
and then provided a “mark-up of existing FINRA Rules that outlines the broad
contours of how a best interests standard for broker-dealers might be developed
as part of the path forward on this most important investor protection
issue.” Retrieved from SIFMA web site, June 10, 2015.

[38]BLACK’S LAW DICTIONARY 252 (9th ed. 2009) (defining “caveat
emptor” as a Latin phrase meaning “let the buyer beware”); see also
Matthew P. Allen, A Lesson from History, Roosevelt to Obama – The Evolution of
Broker-Dealer Regulation: From Self-Regulation, Arbitration, and Suitability to
Federal Regulation, Litigation, and Fiduciary Duty, 5 ENTREPRENEURIAL BUS. L.J.
1, 20 n.77 (2010) (“Caveat emptor is an old property law doctrine under
which a buyer could not recover from the seller for defects in the property
that rendered it unfit for ordinary purposes. The only exception was if the
seller actively concealed latent defects.”).

[39]SIFMA provided a “mark-up of existing FINRA Rules that
outlines the broad contours of how a best interests standard for broker-dealers
might be developed as part of the path forward on this most important investor
protection issue.” Retrieved from SIFMA web site, June 10, 2015.

[40] Legal commentators
also continue to equate the term “best interests” with the requirement of the
fiduciary duty of loyalty. See, e.g.:

·Edward
J. Waitzer and Douglas Sarr, Fiduciary Society Unleashed: The Road Ahead for
the Financial Sector, 69 Bus.Lawyer 1081, 1090 (Aug. 2014). (“these individuals
need to trust that the specialists
they rely upon will keep their best interests at heart … Fiduciary law aims to
promote this trust. It applies to relationships in which one party, the
fiduciary, gains discretionary power over another party, the beneficiary, in
circumstances where both parties would ‘reasonably expect’ that the fiduciary
will exercise this power in the best interests of the beneficiary”)
(Emphasis in original; emphasis
added.)

·Gold,
Andrew S., The Loyalties of Fiduciary Law (December 20, 2013). Philosophical
Foundations of Fiduciary Law, Andrew S. Gold & Paul B. Miller, eds., Oxford
University Press, 2014, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2370598 (“Another
conception of fiduciary loyalty suggests that the fiduciary must act in the best interests of the beneficiary … This
conception can readily be linked to the first conception, given the possibility
that the rules against conflicting interests are designed to increase the
likelihood that a fiduciary will act in the beneficiary’s best interests.”) (Emphasis
added.)

The influential
Restatements of the Law also equate “best interests” or “placing the interests
of the principle first” with the fidicuairy duty of loyalty:

·American
Law Institute, Restatement of the Law of Trusts (Third) § 78. (“[A] trustee
must refrain, whether in fiduciary or personal dealings with third parties,
from transactions in which it is reasonably foreseeable that the trustee’s
future fiduciary conduct might be influenced by considerations other than the best interests of the beneficiaries.”) (Emphasis added.)

·Restatement
(Third) of Agency § 8.01 comment b. (“Although an agent’s interests are often
concurrent with those of the principal, the general fiduciary principle
requires that the agent subordinate the agent’s interests to those of the principal
and place the principal’s interests first
as to matters connected with the agency relationship.”) (Emphasis added.)

[41]FINRA states, in its comment letter of July 17, 2015 to the
U.S. Department of Labor, that “any best interest standard for intermediaries
should meet the following criteria:

·The standard should require financial institutions and their
advisers to:

oact in
their customers’ best interest;

oadopt
procedures reasonably designed to detect potential conflicts;

oeliminate
those conflicts of interest whenever possible;

oadopt
written supervisory procedures reasonably designed to ensure that any remaining
conflicts, such as differential compensation, do not encourage financial
advisers to provide any service or recommend any product that is not in the
customer’s best interest;

oobtain
retail customer consent to any conflict of interest related to recommendations
or services provided; and

oprovide retail customers with disclosure in plain English
concerning recommendations and services provided, the products offered and all
related fees and expenses.”

[42]See, e.g., Study Regarding Obligations
of Brokers, Dealers, and Investment Advisers, Rel. No. IA-3058; File No. 4-606
(a.k.a. the “Rand Report” of 2008), in which over one-fourth of consumers surveyed
related that they paid “$0” for the brokerage or advisory services they were
provided. Since registered investment advisers are required to provide clients
with periodic statements of the fees paid, under the requirements of the
Investment Advisers Act of 1940 and regulations thereunder, and since the
survey included a large number of clients of dual registrants (which fosters
confusion among titles), it is likely that the survey understates the number of
customers of broker-dealer firms who hold such firm. I have personally observed
many, many customers of brokers who believed that their broker provided his or
her services “for free” and “without compensation,” and I have never met a
customer of a full-service brokerage firm who understood all of the ways, or the high amounts, of the compensation received
by the broker or the brokerage firm.

[43] Information
regarding all of the compensation paid by product providers to the brokers is
not provided by brokers to their customers, except piecemeal and in multiple
lengthy documents, such as often 50+ page disclosure statements signed upon the
opening of accounts, mutual fund prospectuses, and various web site
disclosures. Even then, such disclosures are often ambiguous, such as “we may
receive compensation from” a product provider or (in product provider
documents, such as prospectuses) “we may compensate a broker.” Indeed, even the
author – who is trained in reading legal documents and who possesses a broad
and deep knowledge of investment products, often cannot discern the sum total
of compensation provided to a full-service broker resulting from many
investments, given that the sum total includes not only commissions and 12b-1
fees, but also payment for shelf space, sponsoring of seminars for prospective
customers, sponsorship of events at broker-dealer firm meetings, payment of
brokerage commissions including soft dollar compensation, and other forms of
revenue-sharing payments. The disguising of the total compensation paid to
broker-dealer firms and their registered representatives appears to be a
central concern of the broker-dealer community, since if full and complete
disclosures were made of the compensation arrangements, the fact of
differential compensation, and the amounts paid, most customers would likely
choose not to be business with the brokerage firm. I have observed many a
client, once I informed them of my estimate of what they had been paying to
their broker-dealer firm over the past year, become very angry. Yet, a remedy
for their grief is usually not available, as the “suitability” standard does
not require that a broker-dealer firm receive only “reasonable compensation.”
In contrast, the fiduciary standard of conduct requires affirmative disclosure
to the client of all material facts, which by necessity includes all
compensation the fiduciary investment adviser receives, stated in terms that
are clear, concise and understandable by the client. In addition, the fiduciary
standard of conduct requires that compensation received be reasonable.

[46] As Professors Angel
and McCabe observed: “The relationship between a customer
and the financial practitioner should govern the nature of their mutual ethical
obligations. Where the fundamental nature of the relationship is one in which
customer depends on the practitioner to craft solutions for the customer’s
financial problems, the ethical standard should be a fiduciary one that the
advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of
advice in the customer’s best interest – is fraud. This standard should
apply regardless of whether the advice givers call themselves advisors,
advisers, brokers, consultants, managers or planners.” James J. Angel, Ph.D.,
CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers: Fiduciary
or Suitability? (Sept. 30, 2010). (Emphasis
added.)

[54] “Applying the
Advisers Act and its fiduciary protections is essential to preserve the
participation of individual investors in our capital markets. NAPFA members
have personally observed individual investors who have withdrawn from investing
in stocks and mutual funds due to bad experiences with registered representatives
and insurance agents in which the customer inadvertently placed his or her
trust into the arms-length relationship.”Letter of National Association of Investment advisers (NAPFA) dated
March 12, 2008 to David Blass, Assistant Director, Division of Investment
Management, SEC re: Rand Study.

[55] “We find that
trusting individuals are significantly more likely to buy stocks and risky
assets and, conditional on investing in stock, they invest a larger share of
their wealth in it. This effect is economically very important: trusting others
increases the probability of buying stock by 50% of the average sample
probability and raises the share invested in stock by 3.4 percentage points …
lack of trust can explain why individuals do not participate in the stock
market even in the absence of any other friction … [W]e also show that, in
practice, differences in trust across individuals and countries help explain
why some invest in stocks, while others do not. Our simulations also suggest
that this problem can be sufficiently severe to explain the percentage of
wealthy people who do not invest in the stock market in the United States and
the wide variation in this percentage across countries.” Guiso, Luigi,
Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007);
ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP
Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.

[59]Tamar Frankel, Ch. 12, United States Mutual Fund Investors, Their
Managers and Distributors, in Conflicts
Of Interest: Corporate Governance And Financial Markets (Kluwer Law
International, The Netherlands, 2007), edited by Luc Thévenoz and Rashid
Barhar.

[60]In a 2005 study, Professors “Madrian, Choi and Laibson recruited two
groups of students in the summer of 2005 -- MBA students about to begin their
first semester at Wharton, and undergraduates (freshmen through seniors) at
Harvard.All participants were asked to
make hypothetical investments of $10,000, choosing from among four S&P 500
index funds. They could put all their money into one fund or divide it among
two or more. ‘We chose the index funds because they are all tracking the same
index, and there is no variation in the objective of the funds,’ Madrian says …
‘Participants received the prospectuses that fund companies provide real
investors … the students ‘overwhelmingly fail to minimize index fund fees,’ the
researchers write. ‘When we make fund fees salient and transparent, subjects'
portfolios shift towards lower-fee index funds, but over 80% still do not
invest everything in the lowest-fee fund’ … [Said Professor Madrian,] ‘What our
study suggests is that people do not know how to use information well.... My
guess is it has to do with the general level of financial literacy, but also
because the prospectus is so long."Knowledge@Wharton, “Today's Research Question: Why Do Investors Choose
High-fee Mutual Funds Despite the Lower Returns?” citing Choi, James J.,
Laibson, David I. and Madrian, Brigitte C., “Why Does the Law of One Price
Fail? An Experiment on Index Mutual Funds” (March 6, 2008). Yale ICF Working
Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023.

[61]See Choi, James, David Laibson, and Brigitte Madrian. 2010. Why does the
law of one price fail? An experiment on index mutual funds. Review of Financial
Studies 23(4): 1405-1432. [“[Subjects overwhelmingly failed to minimize index
fund fees. Instead, they placed heavy weight on irrelevant attributes such as
funds’ annualized returns since inception. Highlighting these misleading
historical returns caused student subjects (in one of our randomized
experimental treatments) to chase those returns even more intensely, despite
the negative future return consequences such behavior had. Even subjects who
claimed to prioritize fees in their portfolio decision showed minimal sensitivity
to the fee information in the prospectus. Subjects apparently do not understand
that S&P 500 index funds are commodities … In the real world, this problem is likely to be exacerbated by the
financial advisors whose compensation is increasing in the fees of the mutual
funds they sell to their clients. When consumers in a commodity market observe
prices and quality with noise, a high degree of competition will not drive
markups to zero ….” [Emphasis
added.]

[63] One might
reasonably ask why “honest investment advisers” (to use the language of the
U.S. Supreme Court in SEC vs. Capital
Gains) had to be protected by the Advisers Act.Was it not enough to just protect
consumers?The answer can be found in economic
principles, as set forth in the classic thesis for which George Akerlof won a
Nobel Prize:

There are many
markets in which buyers use some market statistic to judge the quality of
prospective purchases. In this case there is incentive for sellers to market
poor quality merchandise, since the returns for good quality accrue mainly to
the entire group whose statistic is affected rather than to the individual
seller. As a result there tends to be a reduction in the average quality of
goods and also in the size of the market.

George
Akerloff demonstrated “how in situations of asymmetric information (where the
seller has information about product quality unavailable to the buyer),
‘dishonest dealings tend to drive honest dealings out of the market.’ Beyond
the unfairness of the dishonesty that can occur, this process results in less
overall dealing and less efficient market transactions.”Frank B. Cross and Robert A. Prentice, The
Economic Value of Securities Regulation, 28 Cardoza L.Rev. 334, 366
(2006).As George Akerloff explained:
“[T]he presence of people who wish to pawn bad wares as good wares tends to
drive out the legitimate business. The cost of dishonesty, therefore, lies not
only in the amount by which the purchaser is cheated; the cost also must
include the loss incurred from driving legitimate business out of existence.”Akerloff at p. 495.

[97] (Per Nov. 2014
prospectus, Growth Fund of America). See also Report of the Joint NASD/Industry
Task Force on Breakpoints (07/22/03) at: http://www.finra.org/industry/mutual-fund-breakpoint-information-investors#sthash.8e9iAGG1.dpuf, stating: “sales
loads on equity funds typically start anywhere from 4% to 5.75% for purchase
amounts up to $49,999. Typically, the sales load percentage applied to purchase
amounts between $50,000 and $99,999 may decline by 0.5% to 1.0%; similar
discounts may exist for purchases at $100,000, $250,000 and $500,000.
Generally, purchases of $1 million or more are not charged any sales load.”

[98] Because investment
advisory fees are I.R.C. §212 expenses, a retirement account's ongoing
investment advisory fee can be paid directly from the account without being
treated as a taxable distribution, under Treasury Regulation 1.404(a)-3(d). See also PLR 201104061, addressing wrap
account fees and investment advisory services in connection therewith.

[99]See Michael Kitces, “Deducting Financial
Planning And Retainer Fees, And The (Tax) Problem With Bundled AUM Fees,” Nerd’s Eye View (blog), May 20, 2015,
stating: “While IRAs are allowed to pay their
own expenses – thus why an investment management fee for an IRA can be deducted
directly from that IRA without a taxable event – and doing so effectively makes
the management fee pre-tax (since it was deducted directly from a pre-tax
account), an IRA should only pay for its own expenses. When an IRA’s assets are
used for other non-IRA expenses, it is deemed to be a distribution from the
account. And when IRA assets are used in particular to pay personal expenses on
behalf of a ‘disqualified person’ (including the IRA owner themselves), it may
be treated as a prohibited transaction under IRC Section 408(e)(2) and IRC
Section 4975, which causes the entire account to lose its tax-qualified status
and be deemed as distributed at the beginning of the tax year. Thus, using IRA
assets to pay the personal financial planning expenses of the IRA owner would
be a deemed distribution of that dollar amount at best, and at worst a
prohibited transaction triggering distribution of the entire account.”
Available at https://www.kitces.com/blog/deducting-financial-planning-and-retainer-fees-and-the-tax-problem-with-bundled-aum-fees/.

[104]Rafael Chodos, Fiduciary Law: Why Now! Amending the Law
School Curriculum, 91 Boston U.L.R. 837, 845 (and further noting that
“Betraying a relationship is more hurtful than merely abandoning a
transaction.”)

Post a Comment

Ron's College Student Success Blog

Please visit www.blogspot.triumphincollege.com.

Search This Blog

Explore WKU's Nationally Renowned Financial Planning Program

The nationally recognized WKU Financial Planning Program challenges and empowers, developing students into exceptional and highly ethical professionals who go on to pursue highly successful financial advisory careers and who possess highly meaningful lives.

Led by Asst. Prof. Andrew Head, CFP® and Dr. Ron A. Rhoades, CFP®, with contributions from other WKU's Finance Department faculty, students receive a solid foundation in the very broad, yet very deep, areas of financial planning and investments. Throughout the curriculum emphasis is placed upon the acquisition of practical knowledge as well as the development of exceptional counseling, presentation, and interpersonal skills.

Check us out! Visit the WKU Finance Department web pages to learn more. For more information about our innovative program and project-based learning, please contact Dr. Rhoades or Professor Head.

About the Author

Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice.